Permanent Revolution: Reflections on Capitalism 9781503612389

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P E R M A N E N T

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P E R M A N E N T R E V O L U T I O N Reflections on Capitalism

W Y A T T

W E L L S

stanford briefs An Imprint of Stanford University Press Stanford, California

Stanford University Press Stanford, California © 2020 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or in any information storage or retrieval system without the prior written permission of Stanford University Press. Printed in the United States of America on acid-free, archival-quality paper Cataloging-in-Publication Data is available upon request from the Library of Congress. Library of Congress Control Number: 2020931103 Cover design: Christian Fuenfhausen Typeset by Classic Typography in 11/15 Adobe Garamond

CONTENTS

Preface: Reflections on Capitalism    vii Part 1:  Capitalist Development   1 1 The Capitalist Breakthrough   3 2 The Treadmill of Innovation   24 3 The Many Faces of the Market   37 4 The Discipline of Finance   55 5 Call the Lawyers   71 6 Ups and Downs   85 7 Off the Balance Sheet   104 8 The Rank and File   112 Part 2:  Capitalist Society   125 9 Undermining Hierarchies   127 10 The Search for Legitimacy   137 11 Faith and Credit   150 12 The Business of Art   159 13 The Dilemma of Tradition   164 14 Capitalism and Progress   174

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P R E FA C E : R E F L E C T I O N S O N C A P I TA L I S M

Capitalism rewrites the human narrative. For most of recorded history, the population lived within narrow confines. Almost half died in childhood, and those who survived to their teens could expect to live into their forties, on average. Most could not read or write. In good times, the majority enjoyed a few luxuries, but most were only two or three bad harvests from destitution. Output expanded slowly, and population growth absorbed a large portion of the gain. Occasionally, disasters like the collapse of the Western Roman Empire, the Mongol invasions, or the Black Death undid the work of generations. These societies were hierarchical, with individuals occupying a well-defined position determined in most cases by birth. In theory, a central ideal—Roman virtue, Confucian order, Christian piety—governed these relationships. History recounted humanity’s effort to realize these principles.

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In the last three centuries, the human condition has changed beyond recognition. Though population has ex­ panded many-fold, living standards have increased sharply. Luxuries such as electric lights, automobiles, and smartphones, unknown in earlier ages, are common. The large majority of children reach adulthood, and for the first time most of the population can read and write. Moral advances have accompanied material ones. By the early twenty-first century, every country in the world had formally banned slavery, and most had substantially expanded the rights of women. The change began in Britain in the eighteenth century, spreading from there to Western Europe and North America and then to other parts of the globe, most notably Japan and South Korea. Historians and economists have christened this transformation the Industrial Revolution, but it is better understood as capitalist development. Entrepreneurs, in their relentless pursuit of profit, commercialized one innovation after another—power looms, steam engines, railroads, electric lighting, automobiles, plastics, integrated circuits, and much more. In so doing, they reshaped the economic landscape, not once but over and over again. This process created wealth in new and often unexpected places and constantly reshuffled the population, disrupting the inherited order. In its place, capitalism offered progress—an ever-rising standard of living and liberation from traditional constraints. The certainties of centuries gave way, not to a new set of verities but to a world in which nothing seemed settled: to a permanent revolution.

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PA R T 1   C A P I TA L I S T D E V E L O P M E N T

Capitalism has no father. No individual or group conceived of and created it. No one even coined the word “capitalism” until the system it connotes dominated the economic life of entire nations. What we call capitalism developed gradually, over centuries, from the actions of people pursuing their own interests without much thought for the broader implications. Capitalists are a distinct type. They organize their business to secure the highest economic return, and when conditions change because of shifting markets or new technology, they reorganize their affairs to suit. Often, capitalists themselves, in the search for new opportunities, set these changes into motion. The object is material wealth, not political power, social status, or spiritual enlightenment. Capitalists tend to be unsentimental and optimistic, with their eyes set on future opportunities rather than past precedents. Most definitions of capitalism emphasize institutions like private property, free markets, and the rule of 1

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law, and indeed all capitalist societies possess these. Yet they are not capitalism any more than a well-maintained aquarium is a fish. Capitalism exists where the values of the capitalist pervade economic life.

1   T H E C A P I TA L I S T B R E A K T H R O U G H

From the dawn of history until well into the twentieth century, most people were peasants—subsistence farmers living in tightly knit communities. Survival depended on common effort. Such was particularly true in the great river basins of the Middle East, India, and China, which relied on irrigation, but even in regions of dry farming like Europe, planting and the harvest required that the entire community work together. Peasant communities had a variety of social gradations, ranging from those who enjoyed some luxuries to others who had barely enough to survive, but most of the time a sense of common interest overrode such divisions—particularly when it came to dealing with outsiders. Although peasants usually generated a surplus, they faced a constant struggle with landlords and tax collectors eager to appropriate it. This class—for the lack of a better term, the gentry—sometimes planned and coordinated valuable public works like irrigation projects, but 3

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for the most part it contributed little to economic life, instead focusing on government and culture. The elite’s levies financed art, literature, religion, and philosophy, and it usually cited these accomplishments as proof of its superiority to the peasantry, on which it depended. Yet the gentry’s own language often revealed the ugly truth of exploitation. Russian landlords spoke of “screwing” money out of peasants; Chinese mandarins devised “squeezes” to get cash; and medieval European nobles used “Bad Customs” to extract payments from villages. A wide variety of social gradations existed within the gentry, but with respect to the peasantry, most recognized their common interest in maintaining control. The gentry were not capitalists. Their primary occupation was politics, and most invested whatever surplus they had in political or cultural pursuits. The rulers described in the Iliad and Beowulf used their wealth to secure and reward followers; Egypt’s pharaohs built pyramids and temples; and medieval Europe’s elite constructed castles and endowed monasteries and cathedrals. When members of the gentry did invest for income, they usually bought more land farmed by more peasants. Even had some of the gentry wanted to become rural capitalists, they would have faced daunting obstacles. The communal nature of farming and the constant struggle between peasants and gentry encouraged the development of incredibly complex systems of ownership for society’s chief economic asset: farmland. Sometimes villages owned land in common, with different families

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having the right to grow crops on certain portions of the common patrimony, while other parts, like meadows, were open to all. A landlord would usually receive rent from the village and perhaps other benefits as well, such as the labor of peasants for one or two days a week in fields that he farmed himself. In other cases, one individual collected rent from land while another had the right to farm it, a right he could lease to a third party. Each society—sometimes it seems each village—had its own rules, but the point was always the same: to eliminate conflict among villagers and between them and the gentry by specifying clearly who was entitled to what. Unfortunately, harmony proved elusive because all interpreted, or reinterpreted, the rules in their own favor, and each conflict usually spawned a new set of rules. Generally, the more advanced and stable a society, the denser the network of rules governing land. Ownership of land meant not control but specific rights—the grain from a certain part of the common fields, or an annual payment from the cultivator of a rice paddy. Any significant innovation required the consent of many, which was usually difficult to obtain because change conferred benefits unevenly or, for some involved, not at all. Intense distrust between the gentry and the peasantry further complicated the situation. Technical progress accrued but at an evolutionary rather than revolutionary pace. In the tenth century, peasants in northern Europe began to use heavy moldboard plows with iron blades that allowed them to exploit fully the dense, rich

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soil of the region. These devices not only made farming possible in hitherto barren areas, but by turning over the heavy earth and bringing nutrients to the surface, they made agriculture more productive. This useful technology spread by osmosis, with villages adopting the new plow when they saw others prospering from it. Generations passed before these devices became standard. Traditional societies also included craftsmen and merchants. The former ranged from the village blacksmith to the masters of large workshops who ranked among the urban elite. Rural craftsmen were usually valued members of their communities and generally shared the outlook of well-to-do peasants. Urban craftsmen sought to create their own version of the peasant village by banding together in guilds that regulated prices, quality, and most important, entry into the trade. Most craftsmen approached economics as did peasants and the gentry, assuming that wealth was more or less fixed and that they could best secure their fair share of it by collective action and legal restriction. The object was to provide a living for all engaged in the trade, albeit not an equal one. The practical result was a welter of rules that governed almost every dimension of each craft and, perhaps more important, an attitude that discouraged innovations which might disrupt the guild’s complex balance of power. In one extreme case, authorities in Danzig, Poland (now Gdańsk), apparently killed the inventor of a loom that could weave several ribbons at once, because it threatened established producers with ruin. Technical

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advances did accrue but, again, in an evolutionary rather than a revolutionary fashion. Merchants, ranging from itinerant peddlers to rich men who owned warehouses and ships, represented the chief exception to this pattern. They existed from a very early date. Early in the second millennium b.c., Assyrian merchants exchanged cloth from southern Mesopotamia for copper and silver from Anatolia, often financing this trade with credit. Their activity had a capitalist flavor to it, but no one claims that ancient Assyria was a capitalist society simply because some of its merchants acted like capitalists, any more than ancient Rome, classical China, Mogul India, or medieval Europe were capitalist societies because they had wealthy merchants. However successful in their own sphere, merchants rarely penetrated other sectors. The individual peasant might not count for much in traditional societies, but collectively they were powerful. Peasants were deeply suspicious of outsiders, whom they believed—often with good reason—sought to exploit them. They were cautious about innovation because they lived close to subsistence. An unsuccessful experiment meant not simply the loss of an investment but quite possibly starvation. Because of the common effort required to farm the land and to resist the exactions of the gentry, peasants faced tremendous pressure to conform. The individualist was rare. These prejudices all worked against the reorganization of rural life along capitalist lines; that is, making constant changes to secure

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maximum economic returns. Peasants were happy to sell their surplus to merchants, but it was difficult for capitalists to penetrate any deeper into the countryside. The gentry were as suspicious of merchants as the peasantry were. They resented the wealth that some merchants accumulated simply by moving things from one place to another. Such fortunes challenged not simply the established power structure but also the moral order: virtue and culture, not an aptitude for buying low and selling high, should determine access to wealth. The gentry controlled the government and imposed various restrictions on capitalists, such as the prohibition by Islam and the Catholic Church on charging interest, and the sharp ­constraints on foreign trade by China’s Ming and Qing dynasties and Japan’s Tokugawa Shogunate. Facing limits on their social and political aspirations, successful merchants often bought their way into the gentry, purchasing land for themselves and offices and titles for their children, in the process abandoning capitalist enterprise. At the same time, outsiders like Jews or Armenians gravitated to trade. Such merchants could amass large fortunes, but as outsiders they faced particularly stiff barriers if they wanted to expand their activities beyond commerce. Traditional societies differed from each other in many important ways. The gentry of medieval Europe was a military aristocracy with a leavening of clerics, whereas that of classical China consisted of well-educated bureaucrats. Peasants grew rice, wheat, or barley, each of which imposed a very different discipline on farmers. Christian-

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ity, Islam, Buddhism, or paganism predominated at different times in different regions. Some governments were despotisms, others republics that sought to balance various social interests. Some states encompassed only a city whereas others extended over much of a continent. Yet the constant struggle between gentry and peasantry, the insularity of peasants, and the complex rules governing the chief industry—agriculture—as well as many crafts, were universal. In almost every case, merchant capitalists played an important role in commerce and enjoyed considerable wealth, but they remained subordinate to the gentry and excluded from the largest industry by far, agriculture. These societies did advance economically, applying new technology and expanding trade so that producers could specialize. The Roman Empire, the Islamic world under the Abbasid Caliphate, Europe during the High Middle Ages, Mogul India, and China during the Sung, Ming, and Qing dynasties all supported large populations with an average per capita income well above subsistence. Yet progress was incremental. Sung China developed blast furnaces that used coke rather than charcoal, and medieval Europe pioneered wind and water mills; but these advances did not inaugurate an industrial revolution. The Chinese and Europeans adopted these advances gradually—in the case of China, only a few provinces ever had coke blast furnaces. Instinctive conservatism accounts for part of this caution. Italians developed double-entry bookkeeping in the medieval era, but

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despite its obvious advantages centuries passed before it became universal even among merchants. Structural factors also limited growth. Money for improvements had to come from current income because credit for capital investment was almost unknown. Markets were small. Much of the population was poor, and many supplied their own wants. Perhaps most important, social and political institutions blocked innovation. Because landholding was fragmented, changing agricultural practices was a slow process, requiring generations. Guilds resisted innovations that might disrupt markets and hurt some members, and they could usually mobilize political support for their efforts. Even in prosperous eras, the output of traditional societies grew only a little faster than the population, and the balance of power within society changed no more rapidly. The development of capitalism in northwestern Europe in the modern era represents the only major exception to this pattern. Somehow capitalism moved from its traditional ghetto, commerce, to dominate most aspects of economic life. The process was complex, involving a variety of interlocking factors; were it simple, it would have happened earlier. Scholars have offered many explanations for this development. Some point to the conquest of the Americas and the opening of direct trade with Asia after 1500, which not only created immense opportunities for profit but provided the precious metals that allowed Europeans to replace barter with monetary exchange.

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These events certainly had extraordinary impact, but the link between them and the development of capitalism is complex. Portugal, which first opened trade with Asia, and Spain, which conquered the New World, were laggards in capitalist transformation, falling well behind the rest of Western Europe in the seventeenth and eighteenth centuries. By the seventeenth century, the Dutch and British were driving the Portuguese from the Indian Ocean and taking an ever-larger portion of the commerce of the Americas, particularly the lucrative sugar trade. The newcomers included many capitalists—the Dutch and British East India companies, sugar planters, and independent merchants—who profited immensely from the New World and trade with Asia. Yet they were the product of societies already well advanced toward capitalism. Other thinkers, most famously sociologist Max Weber (1864–1920), advanced a cultural explanation. Weber attributed the expansion of capitalism to the development of Protestantism, particularly Calvinism. Calvinists did not share the Catholic Church’s suspicion of commerce, as they saw all honest labor as God’s work; and they rejected asceticism, viewing wealth as a mark of divine favor. They considered hard work and saving virtuous, thereby encouraging two qualities important to the successful capitalist. Though plausible, Weber’s argument has flaws. In the fifteenth and sixteenth centuries, the Catholic cities of Northern Italy were the home to Europe’s wealthiest capitalists, who developed key techniques like double-entry

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bookkeeping. The Reformation was, first and foremost, a German phenomenon, and it coincided with the start of a long-term relative decline of the German economy. Britain and the Netherlands, which saw the most rapid expansion of capitalism in the seventeenth and eighteenth centuries, were indeed Protestant, but France, Belgium, and western Germany, largely Catholic regions, were not too far behind. Weber nevertheless asked the right questions. Capitalism is, above all, an approach to economic life that gives profit priority over tradition and social harmony. Its triumph depended on changes in attitudes. The enthusiasm for mercantilist thinking in the sixteenth and seventeenth centuries provides important clues to this cultural transformation. It was the first school of economic thought to address the subject separate from philosophy or religion. Today mercantilist thought gets little respect, because even compared to the economic ideas of the late eighteenth century, it seems crude and sometimes wrongheaded. Its advocates considered precious metals the true measure of national wealth and were obsessed with the danger of overproduction, even though at the time they wrote, poverty was pervasive. At times, their enthusiasm for government control shaded into the ridiculous. In the seventeenth century, French authorities issued 2,200 pages of regulations to the masters of textile workshops, of whom at least a third were illiterate. Yet the mercantilists were revolutionaries, even if few recognized it. Unlike many earlier thinkers, they considered commerce, properly directed, central to

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a healthy society. Thomas Mun (1571–1641), a leading English mercantilist, wrote, “Foreign trade . . . is the great revenue of the King, the honor of the kingdom, the noble profession of the merchant.” Mercantilists proposed eliminating traditional impediments to trade like private tolls, chartering companies and founding colonies to expand commerce, and encouraging manufacturing with subsidies and protection. In short, they offered the first program of economic development as that idea is understood in the early twenty-first century. Governments acted on mercantilist theory. The Netherlands and England organized trading companies to manage long-distance commerce, and subsequently almost all the other major (and many minor) European states followed their example. The maritime nations scrambled to plant colonies in the Americas, on the coasts of Africa, and at strategic points in Asia to develop and control trade. Under Elizabeth I (1533–1603), England standardized the rules for apprenticeships, sharply curtailing the power of urban guilds. Under Louis XIV (1638–1715), France eliminated almost all the extensive customs barriers between the provinces and towns of the northern half of the country. Protection of domestic manufacturing against foreign competition became common throughout Europe. These measures all give evidence of a new attitude among a large part of the political elite. Commerce had graduated from an inevitable evil to a positive good, and profit became a legitimate object of economic activity.

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Mercantilist thought reflected changing political conditions. The early modern era saw the consolidation of the first European nation-states, which soon became locked in mutual rivalries that regularly exploded into war. The expense of these wars exceeded traditional sources of revenue by a large margin, and throughout this period most European governments were desperate for money. The conquest of the New World added to the pressure for change. One country, Spain, monopolized the huge flow of silver from America, giving it a financial advantage over rivals and providing them with strong incentives to develop new sources of revenue. Mercantilist thinkers insisted that expanding commerce and manufacturing would increase government revenue, and officials adopted their suggestions with this object in mind. Experience bore out these calculations. In the seventeenth century, the Netherlands’ vast trade—and the tax revenue it generated—made that country one of Europe’s foremost powers despite its small size and population. Eighteenth-century Britain seized on the example of the Netherlands, making itself Europe’s leading power despite a population less than half that of its chief rival, France. Capitalist development has a large political dimension. Traditional arrangements reflect the existing power structure and usually have the sanction of law. A broad assault on them is impossible without support from political authorities. The expensive political rivalries of early modern Europe gave the continent’s rulers an

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incentive to embrace change, and the success of one government increased the pressure on the others to emulate it. Governments further served the cause of capitalism by encouraging the development of financial markets. War forced them to borrow on an unprecedented scale; not even the Netherlands or Britain could finance military campaigns out of current revenue. The practice of making loans at interest is ancient, but many loans, such as those from landlords to peasants, reinforced the existing social structure. Loans among merchants rested on more straightforward commercial consideration, but even then, money usually moved between family and friends. Centralized markets for trading securities are a relatively recent development. Some Italian cities had such institutions in the sixteenth century, and by the end of the seventeenth century the Netherlands and England both had sophisticated money markets. These institutions developed to handle government debt, which always constituted the majority of trading, but they soon branched into the shares of chartered trading companies and banks, as well as short-term trade credits. The last were particularly important, because until well into the nineteenth century, businesses had far more invested in working capital (raw materials or inventory) than in fixed capital (buildings or machinery). More than anything else, financial markets distinguish capitalist societies from societies with capitalists. They move money not only through space—from those with

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extra cash to those who are short—but also through time, granting money in the present against future earnings. Financial markets permitted businessmen to launch ventures far larger than they could on their own account and, if successful, to reap far greater profits. This process greatly accelerated the pace of change, magnifying the impact of successful ventures. Government officials, clerics, landowners, and others who were not, strictly speaking, capitalists could invest in capitalist enterprise through financial markets. In so doing, they began to think like capitalists, focusing on prospective earnings. Financial markets provided, in the going rate of interest, an economic benchmark for all investments. Landlords expected many things from their property—income but also status, a role in local government, and patronage. If an investor could earn 5 percent on government bonds or commercial loans, however, landowners could not help but think how to secure an equal return from their fields. In Anton Chekov’s (1860–1904) Uncle Vanya, a drama set in a Russia then undergoing its own tentative capitalist transformation, Professor Serabryakov creates a crisis for his family when he proposes to sell their estate, which yields 2 to 3 percent, and to invest the proceeds in government bonds, which offer 4 to 5 percent. The change would almost double the professor’s income but leave the rest of his family, who live on the estate, homeless. Serabryakov insists that he is not a man of affairs, but financial markets have led him to think like a capitalist, even though the investments in question are government

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bonds. Ultimately, the professor relents, but the drama Chekov recounted played itself out over and over again, and the outcome was not always the same. As mercantilist thought flourished and financial markets developed, capitalism penetrated the English countryside. Beginning in the seventeenth century, the country experienced an “agricultural revolution” involving im­provements in almost every aspect of farming. Between 1650 and 1750, the productivity of both the land and labor roughly doubled, providing England’s growing population with a better diet even as the portion of the workforce in agriculture fell to 45 percent, freeing up labor for other endeavors. Throughout this period, farmers sold an ever-larger portion of their output on the market, and it was to satisfy this demand that farmers and their landlords experimented with new crops, tools, and breeds of livestock. Traditional societies had seen growth in agricultural productivity too, but almost never so fast over so long a period of time. The advancing productivity of land and labor, even as the population grew, was particularly impressive; historically, as population expands, societies must bring less-fertile land into cultivation, reducing average yields. In Europe, only farmers in the Netherlands and Belgium—along with Britain the areas most strongly influenced by capitalism—matched the productivity found across the Channel. Elsewhere on the continent, about 60 percent of the population worked the land, and in other parts of the globe the proportion was as high or higher.

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The enclosure movement offers the most striking proof of the new attitude in the English countryside. Starting in the late fifteenth century, landowners sought to abolish traditional rights and “enclose” common land, appropriating it for themselves. At first, political authorities were dubious about this process, halting it in many cases. By the eighteenth century, the situation had changed. The power of the monarchy had declined while that of Parliament, which the gentry dominated, had increased, and the legislature passed a wide variety of acts authorizing enclosures. Such measures represented more than simply another attempt by landlords to squeeze peasants— although they most certainly were that. Enclosure allowed landlords to reorganize their property in a capitalist fashion, abolishing common pastures and fields and consolidating the land into relatively large farms that could operate more efficiently. The process divided peasants. It was a disaster for poorer ones, who could not support themselves on their small plots of land without access to common fields. Well-to-do peasants, however, consolidated their holdings and even expanded at the expense of their poorer brethren, who now became available as hired labor. Most of these peasants remained tenants, but now they could run their farms independent of communal obligations, with an eye to profit. They often worked closely with “improving landlords” to increase agricultural production, which offered both groups higher income—a revolutionary change in the traditionally antagonistic relationship between landlord and peasant. Historians and

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economists have vigorously debated whether enclosure was the determining factor in improving agricultural productivity or but one of several important changes. As evidence of the development of a capitalist outlook in the English countryside, however, enclosure is overwhelming. Most of the gentry and a significant minority of peasants abandoned centuries of tradition to secure higher incomes. The “Industrious Revolution” offers further evidence of changing attitudes in Europe. During the seventeenth and eighteenth centuries, consumption of luxury goods increased dramatically throughout Western Europe, not only among the well-to-do but also among “middling sorts” and even workers. Sales of sugar, tea, coffee, chocolate, tobacco, beer, spirits, pottery, clothing, and furniture all surged, most dramatically in the Netherlands and Britain but also in France, Germany, Belgium, Scandinavia, and Northern Italy. Workers paid for these items by working longer hours with fewer holidays. Capitalist enterprises, ranging from the huge Dutch and British East India companies, to Caribbean plantations worked by slaves, to modest pottery works in the Netherlands and England, supplied most of these goods. This process even touched the countryside through “putting out,” a system under which a merchant provided tools and raw materials to farm families, who made cloth, shoes, and other goods in the quiet months between planting and harvest, which the merchant then retailed. By 1750 at the very latest, the Netherlands and Britain were capitalist societies. For-profit enterprises dominated

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large swaths of the economy—not just trade but manufacturing and agriculture—and financial markets allocated capital. The idea that profit should be the primary object of economic life permeated society. Improving landlords and peasants who experimented with new crops and livestock, craftsmen who organized large workshops, investors who purchased securities, and even farm families that spun yarn in the winter months all followed this logic. Capitalism had reached critical mass: Dutch and British capitalists had the power to transform their societies. The way stood open for the Industrial Revolution, most dramatically manifested in the transformation of cotton textiles in Britain. This industry was ancient, and by the 1700s European merchants were selling huge quantities of cotton cloth, made chiefly in India, throughout the world. At the same time, the spinning and weaving of cotton was relatively new to Britain, and tradition had little hold on it there. Because wages in Britain were much higher than in India, producers had a strong incentive to develop labor-saving machinery, and government protection against foreign competition gave them the time to do so. This serendipitous confluence of a large, established market with a new, dynamic producer had results without precedent. Beginning in the middle of the eighteenth century, a series of innovations revolutionized the British industry, first in the spinning of cotton yarn and then, with the introduction of the power loom, in weaving it into cloth. Output per worker soared twenty-fold between

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1760 and 1860—that is, more than doubling every twentyfive years for a century. Entrepreneurs, whose numbers included craftsmen and farmers as well as merchants, exploited these opportunities relentlessly, using new technology to expand output and reap large profits, much of which they invested in further expansion. Innovation begot innovation: the growing output of yarn encouraged the development of the power loom, and the growing output of cloth encouraged the development of new dyeing and printing techniques. Inexpensive, high-quality cotton cloth flooded world markets, forcing prices down and driving existing producers from business while fueling a huge jump in consumption. English mill owners accumulated large fortunes, in a few cases large enough to rival those of the most powerful landed magnates. The history of the Peel family demonstrates the possibilities. Robert “Parsley” Peel (1723–95), the son of a prosperous farmer, became involved in the cotton textile industry in his native Lancashire as a young man. He was among the first to invest in the Spinning Jenny, which sharply increased the efficiency of spinning, and Peel eventually organized a series of small factories engaged in every aspect of textile production. He earned his nickname by introducing a popular new decoration for cloth that resembled parsley. When Peel died, he left a fortune of £140,000 to be divided among his eight children— more wealth than many aristocrats could boast. His oldest son, also Robert Peel (1750–1830), had an even more remarkable career. Tapping into his father’s contacts, he

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became involved in the cotton textile business as a teenager and was among the first to recognize the potential, first of the spinning mule and then of the power loom. Peel was also one of the first to recognize that orphanages could provide cheap labor, and he employed children on a large scale in his mills. (He subsequently thought better of this particular innovation, regulating child labor in his own mills and sponsoring the first legislation in Parliament to limit the practice.) By 1800, Peel controlled a network of enterprises that employed thousands, and he went on to secure a seat in Parliament and a baronet, becoming Sir Robert Peel. When he died, he left his oldest son £1.5 million, a staggering sum for the day, even while providing generously for his other eight surviving children. Only a handful of aristocrats could claim a comparable fortune. His son, another Sir Robert Peel (1788– 1850), pursued a career in politics rather than business, eventually serving as prime minister. The Peels’ dazzling rise was exceptional, but the revolution in cotton textiles catapulted many to wealth and power. The ambitious drew the obvious conclusion: a successful career in business was a passport to a better life, or at least a wealthier and more influential one. The past defines the possible. For most of human history, economic progress was incremental, the result of sustained effort over decades. No one expected more. The cotton revolution redefined what was possible. If one industry could double productivity each generation for several generations in a row, why not others? In eighteenth-century

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Britain, some other sectors enjoyed impressive growth too, most notably coal and iron. Steam engines, which not only drained coal mines but powered many of the new cotton mills, represented an entirely new industry—historically, an extremely rare development. In the long run, these changes may have been even more important than the expansion of cotton textiles. It was cotton, however, that caught the imagination. The British had created the template. Capitalism, like peasant agriculture, varies over time and from place to place, but certain factors are constant. The search for profit dominates economic life, and entrepreneurs are alert for innovations that promise it. When existing arrangements and institutions, such as the pattern of rural landholding, obstruct capitalist enterprise, they give way—profit has priority over tradition. Financial markets allocate resources, focusing on anticipated returns. By 1800, this system had transformed Britain, and it would eventually do the same for the rest of the world.

2   T H E T R E A D M I L L O F I N N O VAT I O N

Capitalists pursue a specific type of innovation. They do not devise new philosophies or theologies, nor do they often develop public goods like parks or sewers. Most of the time, they leave basic research to others. However beneficial, such projects rarely deliver profits to their promoters. Capitalist innovation nevertheless covers a broad field, addressing the entire process of making and distributing goods and services. Such initiatives are difficult, and innovators fail more often than they succeed. The successful entrepreneur recognizes as false the old saying, “Build a better mousetrap, and the world will beat a path to your door.” Economist Joseph Schumpeter (1883–1950) put it more accurately when he wrote: “It was not enough to produce satisfactory soap. It was also necessary to induce people to wash.” Legendary flops such as the Edsel, New Coke, and the Iridium phone are merely notorious examples of a common phenomenon. As Niccolo Machiavelli (1469–1527) wrote, “There is nothing more difficult to 24

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take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in introducing a new order of things.” The entrepreneur differs from the inventor. The latter devises a new technology while the former commercializes it. Occasionally, the same person performs both roles. George Westinghouse (1846–1914) developed the air brake for railroads and organized a company to make and sell them. More often, though, entrepreneurs exploit innovations devised by others who either fail to recognize the potential of their creations or lack the resources to commercialize them. Xerox developed the “point and click” operating system for personal computers, but Steve Jobs (1955–2011) of Apple recognized its possibilities. Entrepreneurs pursue risky ventures because society offers the successful wealth and prestige. The second Robert Peel not only became rich but secured a seat in Parliament and a title, and his resources and contacts launched his eldest son on a spectacular political career. In the United States, Andrew Carnegie (1835–1919), Henry Ford (1863–1947), and Steve Jobs became not only fabulously wealthy but celebrities, the object of hero worship in many quarters. Only a handful of capitalists reach that level, but successful entrepreneurs do enjoy substantial income and often become leaders in their communities, joining the boards of charities, schools, and churches and sometimes holding public office. In medieval Europe, mounted warriors controlled most of the land, and in classical China, scholars versed in Confucian philosophy

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held most public offices. As a result, medieval Europe had plenty of ironclad knights, and classical China a host of experts on Confucius (551–479 b.c.). A similar dynamic holds in capitalist societies, where the ambitious and talented gravitate toward business. At the same time, many successful entrepreneurs enjoy their work immensely. John D. Rockefeller (1839–1937) said that business “was delightful to me—all the method and system of the office.” A man who appreciated order, he drew great satisfaction from creating Standard Oil and, through it, imposing discipline on the entire petroleum industry. William Lever (1851–1925), founder of Lever Brothers Soap, wrote: “My happiness is my business. . . . There one has room to breathe, to grow, to expand, and the possibilities are boundless. . . . I am not a lover of money as money and never have been. I work at business because business is life. It enables me to do things.” Setting a new enterprise into motion is a complex, demanding task, and many find it exhilarating. This sense of satisfaction holds many entrepreneurs to their work long after they have accumulated all of the money they could possibly use. Joseph Schumpeter divided capitalist innovation into four categories, providing a lens through which to analyze this extraordinarily diverse phenomenon. 1. Introducing New Products.  Introducing an entirely new product entails particularly large risks because entrepreneurs must not only develop the product but find a market for it. Those who pioneered the steam engine, the telegraph, electric lighting, the internal combustion engine,

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radio, and the integrated circuit were, in effect, taking a leap in the dark. In 1919, Chessie Cummins (1888–1968), a self-taught engineer, formed Cummins Engine to produce diesel motors, a relatively new technology with which Cummins had been tinkering for several years. The wealthy Irwin, Sweeny, and Miller families of Columbus, Indiana, which were allied in marriage as well as business, financed the endeavor, taking a controlling stake in it. All involved assumed that diesels, which delivered more power than gasoline engines while using cheaper fuel, would find a ready market, but the search for buyers proved difficult. Only in the late 1930s did Cummins Engine finally identify what became its chief market, the makers of heavy trucks, and only in the late 1940s did the company begin to generate large profits. The long wait frustrated Chessie Cummins, who sold most of his stock in 1947 for about one million dollars—a large sum for the time, but a fraction of what the stock would have fetched a decade later. The Irwin, Sweeny, and Miller clans held on, however, reaping a huge reward for their patience and persistence. Most new products entail less risk, building on existing goods or services. In 1936, Homer Laughlin launched Fiesta tableware, a new line of dishes created under the direction of Frederick Hurten Rhead (1880–1942), the company’s art director. Pottery dates back to the Stone Age, but Fiesta, which featured simple geometric designs and bright colors, represented something new, incorporating the aesthetic of art deco into housewares. Because

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of its novelty, Fiesta carried significant risks for Homer Laughlin; the history of consumer goods is full of daring designs rejected by buyers. In this case, however, Rhead judged the market correctly—the new dishes proved immensely popular. He understood that consumers often use goods to define themselves and that Fiesta allowed buyers to demonstrate their affinity with the latest trends in fashion. At the same time, the design was not so radical that it jarred consumers. Though it hardly ranks with the introduction of the steam engine or electric lighting, Fiesta earned Homer Laughlin large profits, provided steady work for its employees, and gave consumers handsome dishes. Many also considered it an aesthetic triumph, but not Rhead, who preferred earth tones to Fiesta’s bright colors. He was content with commercial success. Individually, such innovations might seem marginal, but collectively they are important. A steam engine that delivers more power for less fuel, a breakfast menu that brings in new customers, or a new packing material that reduces the weight of shipments can transform companies, and the transformation of hundreds of companies can transform society. 2. Developing New Methods of Production and Marketing.  Many entrepreneurs have amassed huge fortunes simply by delivering well-established goods more efficiently. Cotton cloth existed for millennia before the Industrial Revolution. British entrepreneurs made it cheaper with machines like the spinning mule and the power loom. Their accomplishment entailed new organi-

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zation as well as new technology. Historically, the British had produced yarn and cloth in their homes or in small workshops. The new machinery, however, required a central power source, and owners wanted to keep their costly equipment in regular use. To these ends, they organized textile mills, which brought hundreds of workers together under one roof and became one of the symbols of the Industrial Revolution. Henry Ford’s assembly line, a breakthrough in production, represented an even more striking triumph of organization. It did utilize powerful machine tools designed especially for Ford, as well as electric conveyor belts, but the chief innovation was the assembly line itself. By 1913, Ford and his lieutenants had broken down the process of making a car into its myriad parts, assigned each step in the process to a worker or a group of workers, and then arranged these workers along moving lines. The idea was simple, but getting thousands of men and machines to work in tandem to produce an automobile with hundreds of parts represented an extraordinary accomplishment. The new system realized efficiencies that allowed Ford to cut the price of a Model T below three hundred dollars even while earning him a colossal fortune. Ford’s great rival, General Motors (GM), pioneered in marketing. The assembly line, which GM quickly copied, sharply reduced the cost of automobiles. Nevertheless, even the cheapest car, Ford’s Model T, had a price equal to several months’ income for the average American, limiting demand. To address this problem, Alfred

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Sloan (1875–1966) and John Raskob (1879–1950), two of GM’s top executives, created the General Motors Acceptance Corporation (GMAC) to extend loans to auto buyers, allowing them to purchase cars “on time.” This innovation broadened the market, and because Ford was slow to create its own version of GMAC—Henry Ford believed that borrowing for consumption was immoral— it gave General Motors a significant competitive advantage over its chief rival that lasted for several years. 3. Developing New Markets.  Perhaps the oldest form of capitalist innovation entails seeking out new markets. In the second century b.c., Greek and Chinese merchants encountered each other in Central Asia. Realizing that each had goods unknown to the other—silk, perfume, and more—they created the Silk Road, which became one of the great arteries of civilization for the next two millennia. Capitalists of the Industrial Era proved just as quick to take advantage of new markets. After the British forced China to open itself to foreign trade in the early 1840s, European and American merchants rushed in, armed with inexpensive, high-quality cotton cloth and hardware. After another opening in the 1980s—this time at the initiative of the Chinese themselves—Volkswagen, Kentucky Fried Chicken, and Coca-Cola all jumped into the country, making heavy investments in production, distribution, and advertising to sell their wares to China’s huge population. Entrepreneurs can also open new markets in established societies, taking advantage of the rapid changes capitalism

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fosters. In the second half of the nineteenth century, the income of Britain’s working class increased substantially. William Lever, the son of a successful wholesale grocer in the Lancashire textile district, saw this development firsthand. In the early 1880s, he left the family firm and struck out on his own, organizing a business to sell soap to working-class consumers. Over the next twenty years, he made his Sunlight Soap a household staple across Britain even while setting up subsidiaries in Western Europe, the British Dominions, and the United States, where an increase in income roughly comparable to that in Britain created similar opportunities for vendors of soap. In most cases, opening a new market involves nothing so grand. Typical is the pharmacist who upon learning of a town that lacks a drugstore, moves there and opens one. If successful, he will not only earn a comfortable living but in all probability become a leader in the community. A new drugstore will hardly revolutionize society, although it will simplify life for those who live nearby. Multiplied by hundreds of towns and dozens of different types of store, however, the impact is immense. 4. Exploiting New Sources of Raw Materials.  Like the opening of markets, the search for raw materials dates back to the beginnings of trade. Phoenician merchants set up colonies in Spain in the first millennium b.c. to obtain silver, copper, and other metals. With the Industrial Revolution, this process accelerated. The exploitation of Britain’s huge coal reserves, usually by entrepreneurially minded landlords, played a major role in this transformation. In

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the middle of the nineteenth century, American and German capitalists developed the rich coal fields of the Appalachians and the Ruhr Valley, respectively, which fueled economic development in both countries. In the twentieth century, entrepreneurs found oil in the Persian Gulf region, iron ore in Brazil and Australia, copper in Chile and Africa, and much more. Entrepreneurs also devised more effective ways to exploit existing natural resources. For most of history, petroleum was little more than a vexing sludge, but in the 1850s enterprising drillers in Pennsylvania persuaded a scientist at Yale University, Benjamin Silliman Jr. (1816–85), to analyze it. He discovered how to refine oil into kerosene, an inexpensive, safe illuminant, and with this knowledge entrepreneurs in western Pennsylvania built a great industry. German enterprises proved particularly adept at this sort of innovation. Though an Englishman created the first synthetic dyestuff, Germans figured out how to produce it cheaply in large quantities, and they taught textile companies around the world how to use the new dyes. Constant improvement made substitutes cheaper than the natural article as well as more resilient. In the years before World War I, one of the leading makers of synthetic dyestuffs, Badische Analin- und Soda-Fabrik (BASF), devoted large resources to develop what became known as the Haber-Bosch process. Heretofore, nitrates, a critical ingredient for both explosives and fertilizer, came only from a handful of natural deposits in Chile or as a by-product from coke ovens. Supplies were limited and prices high.

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The Haber-Bosch process drew nitrogen from the air—a limitless source. During World War I, this technology kept Germany supplied with explosives, almost certainly prolonging the conflict; but after the peace, it provided the fertilizer without which farmers could not have fed the world’s rapidly growing population. In practice, different types of innovation often go together, sometimes in unexpected ways. After 1900, the growth of the automobile industry opened up a new market for oil companies, whose main product, kerosene, was losing ground to electric lighting. Gasoline, heretofore a less desirable by-product of refining kerosene, suddenly became attractive. In 1913, engineers at Standard Oil of Indiana devised a new refining process that increased the amount of gasoline produced from a barrel of oil twofold, at a stroke doubling the world’s petroleum reserves. Growing demand for oil encouraged drillers to figure out how to punch through once impervious geological formations, opening new sources of supply, even as petroleum companies developed entirely new fields in places like Saudi Arabia. After 1945, chemical firms commercialized a wide variety of plastics, eventually producing them in immense quantities. Plastics require organic (carbonbased) feedstock, and with petroleum relatively plentiful and cheap, chemical companies turned to it rather than coal tar or industrial alcohol, even though the latter worked just as well from a technical point of view. Beginning in the 1990s, the close relationship between the

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production of plastics and the refining of petroleum led oil companies to integrate the two processes, securing significant economies. Capitalist innovation comes on like rising water, first rushing through open channels but eventually filling every niche and crack, reshaping the landscape in the process. Capitalist innovation can be brutal—Joseph Schumpeter dubbed it “creative destruction.” The development of cotton textile production in Britain destroyed India’s huge cotton industry. English producers first drove Indian goods from export markets and then invaded the subcontinent itself, selling at prices that domestic producers who made goods by hand could not match. Lord Bentinck (1774–1839), governor general of India in the early 1830s, insisted, “The bones of the cotton weavers are bleaching the plains of India.” Nor did the British spare their own. Like his ancestors, Andrew Carnegie’s father, William (1804–55), made a good living for many years weaving linen. The application of the power loom to the industry destroyed his livelihood, however, and in 1847 William confessed to his son, “Andra, I can get nae mair work.” The next year, the family relocated to America. Andrew would prosper in the United States, but William failed to adjust and died a few years later, a broken man. Such tales are common. Many profit from change or at least cope with it effectively, but many do not, and their fate can be grim. A willingness to accept such costs is a defining quality of capitalist societies.

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Ever since capitalist development began, observers have predicted its demise. Economist and philosopher John Stuart Mill (1806–73) discussed the possibility in the abstract in the 1850s, and economist William Jevons (1835–82) suggested that Britain’s economic growth would halt once it had exhausted its coal reserves. The Great Depression of the 1930s convinced many that capitalist innovation had finally reached its limits. In 1932, Franklin D. Roosevelt (1882–1945) said: “Our task now is not discovery or exploitation of natural resources, or necessarily producing more goods. It is the soberer, less dramatic business of administering resources and plants already in hand.” In the 1950s and 1960s, rapid economic growth laid such concerns to rest for a time, but in the late 1960s, fears about growing population, environmental degradation, and the exhaustion of natural resources revived fears of stagnation. In 1972, the Club of Rome, a think tank with many government contacts, issued a report entitled The Limits to Growth, which projected that these factors would halt economic growth in the foreseeable future. The 1973 oil shock, which saw petroleum prices quadruple, made this report seem prophetic. Nevertheless, capitalist enterprises found new avenues of growth, particularly in the field of information technology, while dealing with shortages of raw materials by reducing consumption and developing new sources of supply. Between 1980 and 2000, real output in the United States alone almost doubled.

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Entrepreneurs redefine the possibilities of economic life and even of the natural world. The Haber-Bosch process transcended the nitrogen cycle, which had limited agriculture since the Stone Age. The petroleum industry transformed what had been vexing sludge into the world’s most valuable commodity. Every limit is a challenge that if successfully overcome will deliver a profit. This process depends first and foremost on human ingenuity and desire—the closest things the world has to inexhaustible resources.

3   T H E M A N Y FA C E S O F T H E M A R K E T

Markets are abstractions, the aggregate of many transactions. When the volume of these is large enough, they become predictable. A shortage of an article drives up its price, encouraging production and retarding consumption, while a glut works in the reverse. Markets are linked. An increase in the price of one good will send consumers looking for substitutes, while producers will shift resources from other sectors to provide anything in short supply. Prices balance the resources of producers with the income and preferences of consumers. As conditions change, so will markets. This efficiency recommends these institutions to economists, whose ideal is “perfect competition,” a market with so many buyers and sellers that no individual can affect prices. Entrepreneurs view markets differently. They approach these institutions from the inside, as a series of transactions on which they hope to make a profit. Most recognize that when competition is sharp, profits are small. 37

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They seek not to perfect the market but to best it. To this end, entrepreneurs adopt a variety of strategies. Many simply try to do a better job than competitors. The financial trader who is quicker to spot opportunities, the producer who keeps tighter control over costs, and the retailer who better understands the customer can all earn above-average profits. Unfortunately, everyone cannot be above average. Others look to geography. The service station located on a busy highway will do better than one situated on a lonely country road. A plant located close to raw materials and markets will have lower costs than one located at a distance. Again, however, every location cannot be above average. Innovators seek above-average profits by disrupting markets. An attractive new product will command a premium, and more efficient production techniques will increase profit margins. Of course, success begets imitation. Not long after Ford had perfected its assembly line in 1913, General Motors was working on its own version of the same, and after Apple launched the first iPhone, other companies started developing their own smartphones. Nevertheless, duplicating major innovations requires time, and the initial breakthrough often creates a platform from which to launch further advances. As long as innovators do not become complacent, their creations can pay dividends for years. In some cases, innovation changes the nature of markets, creating advantages that endure for decades. Econo-

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mist Joseph Schumpeter considered such advances a separate category of innovation, though in most cases they also entailed advances in production, marketing, or both. In any case, some entrepreneurs have reordered markets to their advantage, most often by exploiting economies of scale or scope or by developing brands. Economies of scale exist when large facilities deliver more per worker and unit of capital than smaller ones. Such economies are not universal. Textile mills have limited economies of scale, and they count employees in the hundreds rather than the thousands. Even when such economies do exist, exploiting them requires care. Facilities large enough to secure economies of scale are expensive. In the jargon of accounting, they have high “fixed costs”—interest, depreciation, and maintenance—that accrue even if they are idle. If a plant operates close to capacity, it can spread these costs over a large volume, reducing expenses per unit. Lower production, however, means fewer units across which to spread fixed expenses. In other words, costs per unit vary inversely with output. Often companies with economies of scale discover that lower prices can boost profit by increasing sales and thereby reducing costs. In the 1870s, Britain’s Brunner, Mond perfected the Solvay process for making alkali, an industrial commodity used to produce soap, glass, paper, and more. The new process was not only much cheaper than the older LeBlanc technique but enjoyed great economies of scale. Brunner, Mond’s plant was soon perhaps

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the world’s largest, supplying nearly half of Britain’s alkali and exporting a substantial amount as well. Because the British market could not support another producer large enough to secure comparable economies of scale, Brunner, Mond dominated the industry. Its policy was simple. It set its price low enough to keep its works operating at close to capacity, leaving the rest of the market to those LeBlanc producers still clinging to life. This formula allowed Brunner, Mond and its successor, Imperial Chemical Industries (ICI), to dominate alkali production in Britain for decades. Steel and paper mills, aluminum and copper smelters, oil refineries, and many other facilities enjoy economies of scale. Only rarely can one plant dominate an entire market, however. More often a handful of companies jockeys for position, creating an “oligopoly.” Under perfect competition, producers have little control over prices, but sellers in an oligopoly account for such a large portion of output that they do influence prices. They also face formidable rivals who will react to whatever they do. In this environment, setting prices is akin to a game of chess, where each action brings a reaction that demands a response. Over time, companies in such industries usually develop informal systems to regulate prices. During much of the twentieth century, U.S. Steel set the price for mass-produced steel (rails, plates, sheets) in the United States. The product of a gigantic merger in 1901, U.S. Steel was not only the largest producer by far but

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possessed immense financial resources and owned the best iron ore and coal mines. Unless backed by some radical innovation, a frontal attack on it would almost certainly fail. At the same time, its rivals were also large companies with substantial resources. An effort by U.S. Steel to destroy them would be very costly and could well fail. Moreover, the American government was leery of monopolies and would probably move against U.S. Steel if it drove its competitors from the market. Acknowledging stalemate, U.S. Steel posted prices high enough for all major producers to earn a profit, and smaller steelmakers shadowed the leader, though some did undercut it slightly to expand sales. The most important challenges to U.S. Steel, however, involved not pricing but innovation. In the early 1900s, Bethlehem Steel learned how to roll structural beams in one piece, improving quality while cutting costs, and in the early 1920s, American Rolling Mill (ARMCO) vastly improved techniques for making sheets, which were in heavy demand from automakers. In both cases, these companies were able to take sales from U.S. Steel, which scrambled to catch up. Yet the basic system of price leadership endured for decades, gradually unraveling in the last quarter of the century only because foreign competition and new technology— “mini-mills” that used electric furnaces to turn scrap into steel—radically altered the industry’s structure. Almost every oligopoly develops a roughly comparable system of “administered pricing,” often dominated by the “price

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leader,” a company perceived as the industry’s strongest. The results usually allow all producers to turn a profit and the most efficient to secure above-average earnings. Economies of scope offer entrepreneurs another opportunity to reorder markets. These accrue when a company uses the same facilities to deliver a variety of goods or services, reducing costs across the board. In 1924, Alfred Sloan announced that General Motors would produce a car “for every purse and purpose.” GM was the creation of William C. Durant (1861–1947), who recognized the potential of the auto industry in the early 1900s and, over the next fifteen years, purchased and merged a variety of car and parts makers into what he christened General Motors. Unfortunately, Durant’s managerial skills were not equal to his vision, and he lost control of the company in 1920 during a financial crisis. Sloan, who came to GM in 1916 when it purchased his company, a producer of roller bearings, ultimately succeeded Durant. He not only imposed order on this rambling collection of properties but devised a brilliant strategy. He assigned each of GM’s auto lines a market sector defined by price, starting with the utilitarian Chevrolet and culminating in the luxurious Cadillac. Heretofore, observers had assumed that mass production delivered identical goods. Henry Ford’s famous quip, that “any customer can have a car painted any color he wants as long as it’s black,” reflected this assumption. Sloan and others at GM recognized that in their industry the largest economies of scale involved parts, which different autos could share. A spark plug was

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a spark plug, whether in a Chevrolet or a Cadillac. By using the same parts across its entire line, GM could secure huge economies of scale while still catering to a wide variety of consumer tastes. For every Cadillac sold, the many parts it shared with Chevrolets became that much cheaper. This strategy helped make GM the world’s largest, most profitable automaker for half a century. It only stalled in the 1980s after a series of strategic missteps and the advent of new techniques like “just in time” inventories, developed chiefly by Toyota, that allowed other auto companies to match its costs at lower levels of output. Economies of scope assume a dizzying variety. Alkali producers using the LeBlanc process survived as long as they did against Brunner, Mond because their technique generated chlorine as a by-product, and the market for it was robust. Historically, pharmacies and hardware stores have sold a wide variety of goods, such as housewares, beyond their main focus. Starting in the 1970s, McDonald’s offered breakfast in its restaurants. Airplane engines and power plant turbines made by General Electric (GE) share key technology. Identifying economies of scope requires imagination, but exploiting them requires organization and discipline. Alkali and chlorine are very different products that go to different buyers. Customers look for different qualities in drugs and housewares, and the buyers of jet engines and power plants have little in common. Channeling a variety of goods or services through the same facilities is challenging, and failure is at

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least as common as success. Yet the efficiencies it brings can yield large profits, and the difficulty of achieving such efficiencies makes emulation hard. When combined with economies of scale, as in the case of GM, imitation becomes even more challenging. Whereas economies of scale and scope deal primarily with production and distribution, branding focuses on marketing. In every community, craftsmen with a reputation for superior work command a premium. Branding builds on this principle. Entrepreneurs develop a product of high and, just as important, consistent quality, and they advertise it relentlessly. Anywhere in the world, consumers who purchase Heinz ketchup, Dove soap, or a Starbucks latte get exactly the same thing—a major convenience. Some brands deliver more. In part, people define themselves by their possessions. Roman aristocrats, Chinese mandarins, and Renaissance princes accumulated art and books to proclaim their culture and sophistication. Capitalist development allows the masses to follow suit. In the eighteenth century, potter Josiah Wedgwood (1730–96) tenaciously pursued the business of aristocrats because he understood that their patronage would attract middle-class buyers, who viewed the elite as arbiters of good taste. When Queen Charlotte of Britain (1744–1818) purchased a large set of dishes from Wedgwood, he launched Queensware, a similar but less expensive line aimed at the middle class that garnered large sales and profits. Such tactics are a perennial of capitalism. In the early twenty-first century, makers of athletic

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shoes aggressively pursue the endorsements of football and basketball stars to associate their wares with physical prowess. Producers of cosmetics hire striking actresses as “spokesmodels” to identify their goods with beauty and glamour. Branding does not always succeed. Coca-Cola has an extraordinary record selling soda to consumers, but in 1985 it could not persuade them to embrace New Coke despite heavy advertising. The company gave consumers no compelling reason to accept a substitute for its flagship product, and they rebelled against the change. Building a popular brand demands not only time and effort but an instinctive understanding of what consumers do, and do not, want. For entrepreneurs, brands have two great advantages. Production of many branded goods, like soap, condiments, and candy, enjoys substantial economies of scale. By expanding sales, branding allows companies to exploit this advantage fully, reducing costs. In the late nineteenth century, the leading miller of oats in the United States was producing more in its large, highly efficient facilities than it could sell. Instead of cutting production, it expanded the market by devising the first breakfast cereal, Quaker Oats. Second, branded goods usually command a premium. In the case of Heinz ketchup or Campbell soups, where the brand simply assures quality, the premium is small. Nevertheless, when output is large, the results add up. In cases where a brand conveys status, like Wedgwood pottery or Mercedes automobiles, the premium can be quite large—as can the profits.

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At first glance, economies of scale and scope and branding seem to negate the free market. Under perfect competition, no one enterprise can significantly affect prices or the overall shape of the market. Yet companies that exploit economies of scale or scope or deploy brands do wield such power, rendering their markets, by definition, imperfect. Perfect or not, economic forces—the cost of production, the preferences of consumers—drive these markets too. Brunner, Mond dominated alkali production in Britain because its prices were lower than those of its competitors. General Motors offered a wider variety of cars at lower prices. Heinz ketchup provides convenience, and a Mercedes sedan impresses the neighbors—or at least some of them. Enterprises often use other devices, unrelated to economic efficiency or consumers’ preferences, to control their markets. In the 1870s and 1880s, Standard Oil’s competitive advantage rested not only on its large, efficient refineries but also on low freight rates. It constructed refineries in places like Chicago, Illinois, where several railroads competed for traffic, and it played the roads off against each other to get the lowest rates. Up to a point, this advantage reflected Standard’s forethought in the placement of its facilities as well as the huge volume of its shipments, which allowed railroads to exploit fully their own economies of scale. Yet some of Standard Oil’s agreements with railroads explicitly required the latter to charge other oil companies more. At least one contract actually rebated to Standard part of the money the

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railroad collected from Standard’s competitors. Railroad companies accepted these conditions because Standard Oil provided them with so much business, but the advantages Standard derived had little to do with its economic efficiency. Before 1914, German companies dominated the production of dyestuffs, making roughly 80 percent of the world’s total. These enterprises held thousands of patents on various dyes and processes for making them, but they used only a small portion of these rights. Their portfolios effectively blocked potential competitors, cutting off technical avenues that challengers might exploit. The German producers actually devoted part of their considerable research efforts, not to improving their own products and devising new ones but to securing patents to block potential challengers. Sometimes enterprises enlist political authorities in their efforts. Between the world wars, chain stores that exploited economies of scale and scope expanded rapidly in the industrial nations, driving many small, independent retailers from business. What the latter lacked in efficiency, they made up for in numbers, and they found defenders among politicians across the ideological spectrum. The result was a series of regulations in the United States, Japan, and many European countries that slowed, though did not halt, the expansion of chain stores. In the early twenty-first century, cab drivers and taxi companies threatened by ride-sharing services like Uber and Lyft have campaigned hard for governments to restrict their rivals, sometimes with success.

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The urge to restrict competition finds its ultimate expression in cartels, agreements among rival enterprises to set prices and allocate markets. Creating such organizations is difficult, not least because members have an incentive to cheat. If one company cuts prices while others hold the line, it will increase sales and profits substantially at the expense of its erstwhile partners. Sooner or later, however, the latter will realize what is happening and retaliate, inaugurating an ugly—and expensive— struggle for markets. Such an outcome can, in the long run, actually strengthen a cartel by convincing members that it represents the only alternative to endless, expensive conflict. Many times, price wars end with the organization of a new, more durable cartel. Organizers of cartels frequently enlist governments. The companies involved often possess considerable political influence, and political authorities usually want stability in leading industries. In Germany, cartel accords had the status of contracts until 1945, exposing any company that broke an agreement to legal sanctions. In the 1930s, the U.S. government imposed a series of cartels on agriculture to stabilize the income of farmers, who constituted a large part of the electorate. During the first half of the twentieth century, many defended cartels. These organizations supposedly moved economic life to a higher plane, replacing the every-manfor-himself ethos of competition with cooperation for the common good. Cartels could coordinate the orderly retrenchment of overextended industries and the system-

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atic expansion of growing ones. During a period of general deflation, like the 1930s, they could stabilize prices. In 1943 in the Sunday Times, Lord McGowan (1874–1961), the leader of ICI, Britain’s largest industrial company, stated: “The era of unrestricted competition was one of strife. It meant certainly the survival of the fittest, but there were too many weak who went to the wall. The element of competition must be present in every healthy economy, but there are few today who would recommend a return to unrestricted competition as a basis for our economy” (emphasis in original). More measured defenders of cartels, like economist Joseph Schumpeter, observed that the results differed little from systems of price leadership and that members of these organizations still competed on quality and innovation. In the long run, however, cartels retard innovation. In the late 1930s, DuPont developed nylon, a synthetic fiber superior in strength and durability to most natural ones. It wanted to sell the new product in Britain, whose textile industry was the world’s largest, but a cartel agreement with Imperial Chemical Industries stood in the way. Each company had assigned to the other all its patents in the other’s home market: the United States for DuPont, and the British Empire for ICI. In third markets where both had interests—Canada, Brazil, and Argentina—they operated through jointly owned subsidiaries. For its part, ICI had an agreement with Courtaulds, the world’s largest producer of rayon, an older synthetic fiber with which nylon would compete. ICI

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sold Courtaulds a variety of chemicals that it needed to make rayon, and ICI had promised not to invade the market for rayon if Courtaulds stayed out of the chemical business. Further complicating the issue, Courtaulds not only dominated rayon production in Britain but was also the largest single maker in the United States, where DuPont was its strongest competitor. After long talks, the three companies agreed in 1940 to create British Nylon Spinners (BNS), which would have exclusive rights to nylon within the British Empire. ICI and Courtaulds would each own half of the new company, and DuPont would receive generous royalties on all sales. BNS was a success—nylon was a terrific product—but it lacked full access to Courtaulds’s considerable experience producing and selling synthetic fiber or to ICI’s immense expertise in the chemical industry, and it could not expand beyond nylon. BNS almost certainly would have done better as a wholly owned subsidiary of ICI, DuPont, or Courtaulds or as a truly independent firm. Since 1945, most developed countries have imposed antitrust or antimonopoly laws that ban, or at least strictly limit, restrictive practices, including cartels. In the United States, such measures date back to the 1890s, but they came to the rest of the world only after World War II. At that time the U.S. government, which presided over the world’s largest economy by far, pressed other nations to impose such rules. At the same time, many Europeans concluded independently that restrictions like cartels accounted in part for the continent’s unimpressive eco-

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nomic performance between the world wars. Of course, businesses are always devising new ways to limit competition, and markets are always changing. Standard Oil’s agreements with the railroads became much less important once it and its rivals began to lay pipelines. New products developed by information technology giants like Microsoft, Google, and Amazon can channel consumers to specific goods and services. The politically powerful will demand special treatment, offering various reasons why competition unfairly penalizes them. Policies designed to preserve competition are always a work in progress. “Natural monopoly” constitutes a small but important category of its own. A few industries—electric, gas, and water utilities and, historically, railroads and telecommunications—have such large economies of scale and such high fixed costs that a community does best with only one such enterprise. The main expense of an electric utility is building and maintaining its grid. Next to that, the cost of generating an extra unit of power is small. The more electricity a utility can distribute over its grid, the more kilowatts across which it can spread these costs, and the lower the expense per kilowatt. Building a second grid to compete with the first will simply double the cost of delivering power. Like many other enterprises with large economies of scale, natural monopolies often discover that reducing prices not only increases sales but lowers costs, delivering higher profits. With competent management, a natural monopoly can realize above-average profits, exclude competition, and deliver low prices—an attractive combination.

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Nevertheless, the power of natural monopolies makes them controversial. In the late nineteenth and early twentieth centuries, many towns in the United States prospered or withered according to railway rates. Most generated enough traffic to support only one road, and its charges were the cost of transportation. The citizens of these communities were, understandably, far more concerned with their own economic development than with the efficiency of railroads. Rates on grain charged by the Louisville & Nashville (L&N) encouraged shippers to send grain to Nashville, Tennessee, whose substantial milling industry ground the wheat into flour. Concentrating the trade in Nashville allowed the L&N to secure economies of scale but created resentment in other cities excluded from the milling business. Natural monopolies also give broad scope to incompetence and arrogance. In the 1960s and 1970s, comedian Lily Tomlin (b. 1947) played a telephone operator whose motto was, “We don’t care. We don’t have to. We’re the phone company.” At the time, the Bell System had a monopoly on telephone service in the United States, and almost every American had at some point dealt with an officious telephone operator. Even in an industry with just two or three competitors, such problems usually resolve themselves because consumers migrate away from abuses. Monopoly provides no such opportunity. Likewise, monopolies are not as quick to introduce incremental advances as competitive industries. A natural monopoly cannot use such an innovation to lure customers from rivals, nor need it fear

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losing customers because a competitor offers such an improvement. Capitalist societies usually regulate natural monopolies or resort to government ownership. Though often touted as improving efficiency, such policies serve other goals. In the United States, railroad regulation helped smaller companies and communities secure rates comparable to those enjoyed by their larger rivals. The government allowed the Bell System to charge higher tolls on long-distance calls in exchange for reducing charges on local ones. Such requirements are not unreasonable—economic efficiency is not the only virtue, even in a capitalist society. Preserving smaller businesses and communities may well be worth somewhat higher prices. Broader access to local phone service may be worth paying more for long distance. Yet regulations that impinge on companies’ ability to earn a profit can cripple them, outweighing any benefits. After 1900, American railroads faced rising costs, but the federal government, bowing to pressure from shippers, refused to let them increase rates. This decision cut sharply into profits, limiting the ability of railroads to finance investments needed to cope with the rapid growth of traffic underway at the time. After the United States entered World War I in 1917, shipments spiked and the rail net went into gridlock. To resolve the problem, Washington not only had to allow sharp increases in rates but had to invest public money in improvements. After the war, the American government significantly altered regulations, making it easier for railroads to recoup expenses. Soon,

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however, the roads faced a new challenge in the form of competition from automobiles, trucks, buses, and eventually airplanes. By 1960, at the very latest, railroads’ natural monopoly had shrunk to cargos like grain and coal, with a low ratio of value to weight, and they had to keep rates down on such goods because high charges would cripple traffic. Unfortunately, the system of regulation made it difficult for railroads either to consolidate or to abandon unprofitable operations, and it remained in place until 1980, saddling roads with heavy losses. Such outcomes are not inevitable. During the century after Alexander Graham Bell (1847–1922) invented the telephone, callers communicated over wires strung between telephones. The system was a natural monopoly because a second system of wires would double costs without significantly increasing traffic, forcing prices higher. The government tightly regulated the Bell System, which monopolized phone service, and—Lily Tomlin notwithstanding—consumers enjoyed good service at low prices between the 1920s and the 1970s. In the 1970s, however, the development of electronic switching and microwave transmission weakened the Bell System’s monopoly, particularly over long-distance traffic, and beginning in the 1980s, cell phones brought competition to every corner of the business. Fortunately, the United States and most other capitalist countries relaxed regulations fairly quickly in response to changes in technology, allowing a relatively smooth transition from monopoly to competition.

4  THE DISCIPLINE OF FINANCE

Finance elicits both fascination and suspicion. Money markets trade arcane instruments like equities, bonds, futures, and options. Wealth appears and disappears rapidly, often for reasons that defy easy explanation. For many, finance represents the ultimate challenge, demanding intelligence and courage, but others consider it little more than a fraud imposed on the rest of society by sophisticated grifters. Yet finance is far more than a complex game. Money is the universal commodity. Every enterprise requires capital, and financial markets are the chief source of it. Moreover, these institutions determine the price of money—the interest rate—which effectively separates success from failure. Enterprises that earn more than the cost of capital survive and grow, while those that fall short wither. Financial transactions are ancient, predating money itself. Archaeologists have unearthed Mesopotamian documents recording loans, often denominated in grain. In the 55

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late Roman Republic, bankers had considerable influence, financing politicians like Julius Caesar (100–44 b.c.). Mosaic Law set rules for loans, and the New Testament briefly mentions bankers. These loans, however, usually served political and social ends as much as economic ones. Roman bankers provided politicians with money to win office, receiving repayment from either the public coffers or the loot of conquest. After a bad harvest, peasants borrowed from landlords to feed their families and buy seed for the next planting, saving the former from starvation but reinforcing the latters’ authority. Loans between merchants to finance trade followed a more familiar commercial logic. By the late medieval era, merchants in Europe and the Middle East used bills of exchange to extend loans and transfer money, and a few specialized in such devices, becoming bankers. China and India had roughly comparable mechanisms. Such arrangements had limits. They only financed commerce, not manufacturing or agriculture. No money market existed—bankers lent to people they knew. Outsiders who wanted either to borrow or to invest could not easily do so. Financial markets in the modern sense emerged in sixteenth- and seventeenth-century Europe, largely because of government demand. The expense of constant warfare exceeded government revenue by a large margin, forcing political authorities to borrow on an unprecedented scale. To raise money, officials turned to merchants, who not only had money to lend but, perhaps more important, experi-

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ence with finance. Governments and merchants resorted to a wide variety of devices to raise money, some of which worked better than others. The Bank of England represented perhaps the most successful of these arrangements, providing a model for other countries. The English government chartered it in 1694 to raise money for its ongoing war with France. The Bank drew heavily on Dutch examples—the King of England at the time, ­William III (1650– 1702), was Dutch—but it also contained new elements. It loaned all its capital, £1.2 million, to the government, and it received not only interest on this money but also the authority to issue £1.2 million in banknotes, which it loaned out. Though legally obliged to redeem these notes on demand in gold or silver coin, the Bank had nowhere near £1.2 million in precious metal. Notes’ value rested on the loans extended by the Bank to the government and to merchants, and from the start this paper circulated at face value. The initial subscribers to bank stock numbered 1,268, and though merchants predominated, investors included a significant number of aristocrats, lawyers, clergymen, and government officials. The Bank became a major source of commercial credit as well as money for the government, and in time the price at which it made loans became the interest rate for the entire London market. Once established, financial markets expand. Like other capitalists, financiers constantly innovate, taking every opportunity to bring together those who have money to invest with those who need cash. Over the centuries, they have devised a dizzying array of bonds, stocks, futures,

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options, policies, funds, and more. As in other fields of capitalist endeavor, not all innovations succeed. In 1720, London and Paris saw, respectively, the South Sea and Mississippi Company bubbles, which created financial chaos when the overambitious schemes of their promoters unraveled, saddling many investors with heavy losses. Despite setbacks, however, the progress of finance over the long term has been inexorable, bringing more and more of society into its orbit. In the 1920s, the makers of “consumer durables” like automobiles began to extend credit to buyers. Many workers, whose financial dealings heretofore had rarely extended beyond a savings account, found themselves budgeting to meet monthly loan payments. Credit conveyed advantages but also imposed discipline. As financial markets grew, they altered ideas about money. It ceased to be simply a medium of exchange or a store of value, becoming instead something that, properly deployed, earned money. Industrialist and philanthropist Andrew Carnegie came from a working-class family, and as a young man he became an assistant to Tom Scott (1822–81), one of the leaders of the powerful Pennsylvania Railroad. Scott introduced Carnegie to capitalist investment, loaning Carnegie the money to purchase stock in a venture which Scott had helped organize. When the company’s dividend arrived, Carnegie wrote: “It gave me the first penny of revenue from capital—something that I had not worked for with the sweat of my brow. ‘Eureka,’ I cried, ‘Here’s the goose that lays the golden eggs.’ ” Once people think of money as something to invest for profit,

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they begin to view all transactions through this lens. The object becomes maximum economic return, adjusted for risk. Of course, people retain other interests: family, religion, politics, art. Yet these pursuits cease to be the object of investment and become instead the beneficiaries of income from investments. Indeed, schools, churches, hospitals, and museums invest their endowments through financial markets. In this way, the values of capitalism permeate society, even affecting individuals and institutions that are not, strictly speaking, capitalist. Finance both supports and disciplines enterprise. Every business requires capital, and financial markets are the largest source of it. Large endeavors like railroads and electric utilities sell stock and bonds to the public to lay track and string wire, paying dividends and interest once their systems are up and running. In most cases, however, the process is not so straightforward. Selling the securities of small, untested enterprises on financial markets is difficult. British pioneers in the cotton, iron, and machinery industries during the Industrial Revolution drew on family and friends for money to launch their ventures, as well as on local investors with whom they were personally acquainted. Once their enterprises showed a profit, a large part of the earnings went to finance expansion. Such practices remain common in the early twenty-first century. Financial markets assist this process in two important ways. First, they provide credit for inventory and raw materials—working capital. Because such loans have collateral, bankers will often extend them to untested ventures, and

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many industries require more working capital than fixed capital (buildings and machinery). Second, beginning in the second half of the nineteenth century—the exact sequence differed in each country—financial markets began to trade the securities of established industrial companies that had a solid record of profit. Such companies could now raise funds without too much trouble, and just as important, those who had organized and guided them to success could realize large gains by selling their securities to the public. Entrepreneurs from Andrew Carnegie to Bill Gates (b. 1955) have become immensely wealthy doing just that. The prospect of such riches encouraged the development of venture capital—individuals and firms that invest in promising new enterprises and often play a role in their management. Many of these initiatives still fail, but the profits from one success can pay the cost of several duds. Financial markets do not simply find the money for such investments but, in a sense, create it. When commercial banks loan out money on deposits, the deposits do not vanish. Their owners can, and usually do, draw on this cash even as borrowers spend money from loans. When a company sells securities, it gets cash while investors receive an asset that they can sell or borrow against. In the short run, the process depends on a robust financial system in which investors can convert claims against the future into money. In the long run, it depends on borrowers living up to expectations—retailers selling inventory, homeowners retiring mortgages, new compa-

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nies earning a profit. Successful investments redeem the credit created to finance them. Financiers have two roles in this process. First, they must balance future claims against present ones, keeping enough cash on hand to avoid becoming “embarrassed.” Second, they must divine the future, determining which ventures will succeed, and which will not. Financial markets also impose discipline. In some cases, the process is simple. An enterprise that borrows at 5 percent to carry on a business earning 4 percent will not last long. Even companies that do not depend on loans will face severe pressure if they cannot earn at least the going rate of interest. Investors, realizing that other opportunities offer better returns, will grow restless, demanding changes or withdrawing their money, if they can. Even if such enterprises somehow hold on to investors’ capital, they will have difficulty attracting new money to expand or even to maintain existing facilities. These forces play out differently according to the circumstances, but in the long run the pressure on underperforming enterprises is nearly irresistible. J. P. Morgan’s (1837–1913) reorganization of the Richmond Terminal in the 1890s represents a classic case of how these pressures can affect a large, publicly held company which relies heavily on borrowing. The Richmond Terminal was a holding company that controlled a network of railroads in the American South through a host of subsidiaries. Unfortunately, the men who had assembled this empire paid little attention to integrating or

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even maintaining its operations, instead focusing on insider deals that lined their own pockets—in particular, selling properties they controlled to the Terminal at inflated prices. Even under the best circumstances, the system barely earned enough to pay the interest on its debts, and money to maintain facilities, much less modernize them, was scarce. After 1890, the South slipped into recession, and the organization’s revenue fell below what it needed to service its debts. Soon not only the Richmond Terminal but also its main subsidiaries were in default. At this point, J. P. Morgan, the greatest banker of the day, intervened. Heretofore, he had avoided dealing with the Richmond Terminal because he did not trust its leaders. By 1893, however, the situation was so desperate that these men ceded absolute authority over their system to Morgan. He had the Terminal declared bankrupt and secured authority to reorganize it. Over the next few years, Morgan and his associates restructured not only the company’s finances but its entire administration. They abandoned a few subsidiaries that they considered hopeless, merged all the Terminal’s other properties into one company, the Southern Railroad, and put Samuel Spencer (1847–1906), an experienced railroad manager close to Morgan, in charge of the new organization. The Southern authorized $140 million in 5 percent bonds, $75 million in 5 percent preferred stock, and $160 million in common stock. J.P. Morgan & Co. exchanged most of these securities for the dozens of different types of stocks and bonds issued by the Terminal and its many subsidi­

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aries, in the process not only simplifying the corporate structure but also forcing investors to take a substantial “haircut.” Bondholders had to accept lower interest rates and in some cases exchange part of their bonds for preferred stock, which only paid a dividend if the company showed a profit. Owners of common stock fared worse— most had to put more money into the Southern simply to keep their shares. Morgan also somehow managed to sell part of the bonds and preferred stock to the public, raising funds for badly needed improvements. These maneuvers reduced the organization’s interest payments by over four million dollars a year, allowing it not only to service its remaining debts but also to invest in improvements, thereby laying the foundation for future growth. Kenricks & Co. stood at the opposite end of the spectrum. Whereas the Richmond Terminal was a publicly held company with heavy debts, Kenricks was a closely held family firm that borrowed modestly, usually against solid collateral like inventory or raw materials. These factors insulated it from financial pressure. A producer of hardware located in Birmingham, England, Kenricks rose to prominence in the nineteenth century by developing superior enameled cookware that it sold in large quantities at high prices. Profits financed expansion and made members of the Kenrick family wealthy, allowing them to become leaders in the Birmingham community. In retrospect, the business stagnated after 1900 because of stiff foreign competition and weak management, as the abler members of the family devoted themselves either to

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public service or to other businesses. Nevertheless, the company continued to generate respectable profits and to pay a good dividend until the early 1920s, when the sharp recession after World War I created a crisis. Initially, managers assumed that losses were a passing phenomenon tied to the downturn of the broader economy, but better times in the mid-1920s for Great Britain as a whole brought no improvement at Kenricks, which had to suspend its dividend. To reverse its fortunes, the company started producing bathtubs, which both utilized its experience with foundry work and enameling and took advantage of Britain’s booming housing market. Bathtub production, however, entailed significant economies of scale, and Kenricks, which made tubs in its existing works, failed to exploit these possibilities. It had lower output and higher costs than its chief competitors. In the end, the new initiative consumed substantial resources while delivering little if any profit. Between 1939 and 1945, war contracts provided a respite, but by the late 1940s Kenricks was in desperate straits. The firm was running substantial losses and drawing heavily on its bank, which by the early 1950s was balking at further credits. The family reluctantly considered selling the business or even closing it, but three factors encouraged perseverance. First, a new team of Kenricks—Arthur Wynn (1903–63) and William (1908–81)—took charge of the business, bringing with them badly needed energy and imagination. Second, during World War II, the firm had, at the government’s urging, developed expertise in the relatively

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new field of die-casting. Finally, in 1949, the company had obtained rights to a superior new caster for furniture made by this process. Wealthy members of the Kenrick clan extended loans to the company, partly out of a sense of family solidarity and partly because they recognized that the new regime offered their best hope of recouping their investment in the firm. Their example encouraged the bank to exercise forbearance, while the dire situation led workers to make concessions too. The new management, armed with an innovative new product, delivered. By the early 1960s, Kenricks was again earning solid profits and paying a regular dividend. Survival came at a price, however. Kenricks closed the foundry that for 150 years had been the core of its business, abandoning the production of cookware and bathtubs and dismissing many employees. Henceforth, it would focus on die-casting. For a generation, the company had ignored pressures that would have forced a less-entrenched enterprise to close or to reorganize radically. By the 1950s, however, Kenricks had exhausted its resources. Had it not reinvented itself as a specialist in die-casting, it would have closed, a victim of its failure to deliver financial returns. The large rewards that markets give enterprises with above-average returns add to the pressure on those that fall short. Financial markets value companies according to expected earnings, not the size of their capital. Two companies on course to earn one million dollars a year will have about the same market value, even if one uses ten million dollars in capital and the other only five million.

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An entrepreneur who takes control of an existing enterprise and increases its earnings can secure a large return fast because larger profits will translate into a higher market value. Such operations usually focus on weak concerns because they are relatively cheap and improving performance entails fewer challenges, but any enterprise that fails to fully exploit available opportunities is vulnerable. In 1988, RJR/Nabisco, a huge company which earned large profits selling cookies and cigarettes, became the object of a frenzied bidding war because some observers had concluded—correctly—that its management had a cavalier attitude toward costs and that more disciplined leadership could reduce expenses and deliver higher earnings. Perhaps no financial operator has ever exceeded Jay Gould (1836–92) in the scale and audacity of such operations. In the twenty-five years before his death, Gould bought and sold railroads throughout the United States, for a brief time even controlling a system that spanned the entire continent. An ambiguous figure, he often channeled money from companies he controlled into his own pocket, using devices that were certainly unethical and possibly illegal—corporate law in the United States at the time was still murky. Yet Gould was also a strategic genius who saw value that others had missed. He first came to public attention in 1868 when he secured control of the Erie Railroad in the infamous “Erie War,” a contest in which Gould and his associates bested the formidable Cornelius “Commodore” Vanderbilt (1794–1877). The Erie connected New York City with the Great Lakes, but

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it was bounded on the north by the New York Central Railroad and on the south by the Pennsylvania Railroad, both of which possessed better organization, superior physical plant, and stronger finances than the Erie. To escape this unpromising position, Gould began to purchase the stock of railroads that connected these three roads with the west, particularly Chicago. He reasoned that if he could buy a controlling interest in these lines, he could funnel all their eastbound traffic over the Erie, expanding its profits and raising the value of its securities while providing the resources for badly needed improvements. Gould’s scheme failed, but not because it was unsound. The Central and Pennsylvania learned what Gould was doing before he had completed his design, and they used their superior financial resources to outbid him for connecting roads. Subsequently, they integrated these properties into their existing operations, creating systems that stretched from Chicago to the Atlantic coast and constituted a key part of the American transportation system well into the twentieth century. Soon thereafter, Gould lost control of the Erie, but he soon found other properties with which to occupy himself, most notably the Union Pacific (UP) and the Missouri Pacific. There he demonstrated his usual mixture of unscrupulous pilfering and strategic brilliance—in the case of the UP aggressively developing its underappreciated mineral resources while selling to it other properties he controlled at inflated prices. Since Gould’s day, reforms have limited the sort of insider dealing on which he thrived. The search for enterprises with

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unexploited value, however, remains a staple of finance in the early twenty-first century, with organizations like Kohlberg, Kravis, Roberts, and Blackstone specializing in buying, reorganizing, and reselling such companies. Financial markets have always had critics who consider them a distraction from the production and distribution of goods and services. Thomas Jefferson (1743–1826) denounced the “paper aristocracy” that he claimed drained productive enterprise, particularly agriculture. Andrew Jackson (1767–1845) echoed this theme in the 1830s, as did William Jennings Bryan (1860–1925) in the 1890s. In 1914, Louis Brandeis (1856–1941), a lawyer who subsequently became a justice of the Supreme Court, published Other People’s Money, which excoriated financiers such as J. P. Morgan for creating unwieldy behemoths like U.S. Steel. His contemporary, economist Thorstein Veblen (1857– 1929), postulated that financial markets actually discouraged efficiency, and imagined an economy run by engineers rather than businessmen. In the United States, such positions were the province of liberal or progressive thinkers, but elsewhere nationalists and even fascists have taken them up, complaining that financial pressure destroys traditional social and economic arrangements. Some give the argument a racial twist, citing the prominent role that some Jews have played in financial markets as proof of the alien nature of these institutions. These critics objected not so much to the imperfections of financial markets, which were (and are) significant, but to their existence. Between the ratification of the Constitu-

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tion and the Civil War, each bank in the United States issued its own notes. Many were careless about the process, and a few were little more than state-chartered counterfeiting shops. Between 1791 and 1811, and again between 1816 and 1836, the First and Second Banks of the United States (BUS) imposed order. They accepted the notes of other banks at close to face value and redeemed them immediately, demanding either gold or silver coins or BUS notes. Bankers across the country knew that if they issued too many banknotes, an official from the BUS would show up at their door with a satchel full of their paper and clean out their vault—a prospect that encouraged restraint. Thomas Jefferson opposed the first BUS and Andrew Jackson destroyed the second, not because these institutions failed in this and other important tasks but because they succeeded. In both of its incarnations, the BUS centralized and extended the reach of financial markets in the United States. Merchants in New Orleans and New York paid about the same rate of interest, as did mill owners in Massachusetts and planters in Georgia. Businessmen throughout the country could avail themselves of capital from New York, New England, or Britain. Small farmers, Jefferson’s and Jackson’s chief constituents, could avoid the discipline of financial markets if they eschewed debt, but if they borrowed to purchase more land or to recover from a bad harvest, they too became subject to this system. As far as Jefferson, Jackson, and many of their followers were concerned, better monetary chaos than a financial system that dominated economic life so completely.

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Financial profit is inseparable from economic efficiency, however. Assuming competent accounting and reasonably efficient markets, profit is simply the surplus above and beyond the cost of production, and it pays for everything else in society—art, literature, religion, philosophy. Profit is necessary, though not sufficient, for “the good life.” Financial markets enforce efficiency, requiring enterprises to earn at least the going rate of interest and richly rewarding those that do better. When Andrew Carnegie sold Carnegie Steel to J. P. Morgan’s U.S. Steel combine in 1901 for a staggering $480 million, he affected disinterest in finance. He reportedly said that he and his partners “knew little about the manufacture of stock and bonds. They were only conversant with the manufacture of steel.” In fact, Carnegie was a seasoned financial operator who had launched his steel company in the 1870s with the profits from earlier speculations. He could feign indifference to finance precisely because Carnegie Steel was by any financial calculus immensely successful, generating huge profits. Its resources allowed Carnegie to dictate terms to Morgan. Had his company been financially weak, the situation would have been different—as the leaders of the Richmond Terminal could attest.

5  CALL THE LAWYERS

Capitalism rests on law. Every major transaction requires a contract, as do many minor ones. The equities, bonds, futures, and options that financial markets trade are legal devices, as are the corporations that account for so much of economic activity. Before launching any large project, the prudent entrepreneur consults an attorney. Good legal advice does not guarantee success, but the lack of it can be disastrous. Such was not always the case. Historically, capitalist enterprise was largely confined to commerce and constituted a relatively small part of economic life. The law of property and contracts focused on land and the many, often vague rights associated with it. To protect themselves from misunderstanding or outright fraud, merchants relied not so much on contracts as on dealing with people they knew— ideally family. Failing that, they found agents among members of their own religious or ethnic community. Agreements rested more on social solidarity than legal sanctions. 71

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As capitalist enterprise grew in early modern Europe, the reliance on law gradually expanded. Entrepreneurs continued to draw partners and agents from among friends and family or religious and ethnic brethren—a practice still common in the early twenty-first century. The growth of trade, however, forced them to deal with many suppliers and customers of whom they knew little. Moreover, the expansion of capitalism into agriculture and manufacturing took entrepreneurs into the unfamiliar realms of land and labor law. Inevitably, they turned to the legal profession, in the process changing it in a subtle but profound way. Initially, lawyers provided capitalists with the same services that they offered other clients— drawing up contracts, reviewing deeds, and managing cases arising from disagreements over these instruments. As the part of their business originating with entrepreneurs grew, however, attorneys turned their minds to the challenges capitalists faced. Legal innovation became part of the larger stream of capitalist innovation. The “through bill of lading” is typical of this process. Designed for the railroads, it is a document that accompanies a package as it moves between shippers to its final destination, making sure that goods go where they are supposed to go and that everyone along the way gets paid. This device substantially reduced both the volume of paperwork and the opportunity for errors in shipping. Ultimately, capitalism transformed the law, at least with respect to property. In most traditional societies, property consists of “rights.” A peasant might have the

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right to farm a certain field, or part of that field, while a landlord could have the right to an annual payment from that peasant. Membership in a guild might convey the right to practice a specific trade in a certain town. An aristocrat could have the right to collect tolls from boats sailing on a river abutting his property. In capitalist societies, property has a different meaning. Entrepreneurs are always redeploying their resources to secure higher profits. For them, specific rights are of limited use and even, in the case of guild restrictions or private tolls, a positive hindrance. They need effective control of physical assets. The enclosure movement in England constitutes a classic example of this transformation of property rights. In medieval and early modern England, peasants usually had rights to strips of land in large fields that they farmed in conjunction with others. Villages also had common pasture on which all could graze their livestock. Landlords collected rent and other payments from peasants. Starting in the fifteenth century, many landlords sought to enclose—or appropriate—pastures held in common by peasants. Most planned to use the land to raise sheep, catering to the growing demand for wool. Enclosure made limited progress, however. Peasants usually resisted, and under the Tudor monarchs the government restricted the practice—the prospect of replacing people with sheep did not please the country’s rulers. In the seventeenth century, changing economic and, ultimately, political conditions gave enclosure new impetus. The period saw the first stirrings of the agricultural revolution that would

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by the late eighteenth century transform English agriculture, greatly improving the productivity of land and labor. One aspect of this multifaceted process entailed consolidating the scattered holdings of peasants, along with common land, into compact farms, each under the direction of one farmer. Such reorganization would simplify management, allowing more rapid adoption of new techniques and technology and faster adjustment to changing market conditions. In this guise, enclosure benefited not only landlords but well-to-do peasants, who became undisputed masters of their own farms, although poorer peasants would find themselves hard put to support themselves without access to common land. At first, enclosure proceeded by agreement, with a mixture of incentives and pressure encouraging poorer peasants to go along. By the early eighteenth century, those orchestrating enclosure usually sought a decree from the Chancery Court to ratify the change legally. Enclosure accelerated after 1760. The promise of more efficient management accorded with the broader current of agricultural reform transforming the English countryside. Parliament, in which landlords constituted a large majority, passed hundreds of bills enclosing estates, providing legal sanction for the process and bypassing resistance. Wealthier peasants supported enclosure— Parliament usually refused to consider enclosure unless farmers of at least three-quarters of the land, by value, agreed. In 1801, Parliament passed a general enclosure law, so that it no longer had to enact a measure for each estate, and by 1830 the process was largely complete. English

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landlords had clear title to the land, which they rented to farmers in large, compact blocks on long-term leases. The transformation of law took different courses in different countries. In Britain, the process was incremental, advancing with the growing influence of improving landlords, merchants, and ultimately manufacturers. Starting as early as the fifteenth century and continuing well into the nineteenth, a mixture of court decisions and parliamentary legislation remade property and contract law, giving it a shape consistent with capitalist development. France moved suddenly. Many in eighteenth-century France criticized the traditional order, which was rife with guild restrictions, private tolls, provincial tariffs, and complex manorial obligations, but before 1789 little changed. Powerful interests profited from existing arrangements, and the kings after Louis XIV were not strong enough to force change. The revolution radically altered the situation. In the course of just a few years, peasants received title to the land they farmed, while the intricate legal superstructure of the old order vanished. Ultimately, the Code Napoléon reshaped the law, making it far more accommodating to capitalist enterprise. In Japan, by contrast, change came from the top. Those who seized power in the 1868 Meiji Restoration believed that Japan could resist encroachment from Western powers only by reshaping its society. Among their first measures, they freed the peasants, who had been tied to the land, and awarded them title to the plots they farmed. Landlords received compensation in the form of government bonds. Comprehensive

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property and commercial codes followed fairly soon thereafter. Legal reform is a political process, and it is no surprise that different countries followed different paths. The destination was the same, however. Gradually or suddenly, whether driven by popular pressure or directives from the top, capitalist societies narrowed and consolidated property rights. Traditional privileges like private tolls disappeared, and property became synonymous with control of a specific asset. As they narrowed and consolidated property rights, capitalist societies also created a new form of property: the business corporation. Initially, almost all businesses were proprietorships (individually owned) or partnerships. Proprietorships depended on the capital and credit of one person, while partnerships pooled the resources of several. In the latter case, each partner was usually responsible for the debts of the entire business, so prudent entrepreneurs only partnered with those whom they trusted implicitly, limiting the size of such ventures. The death or retirement of a proprietor or partner required the closure or reorganization of the enterprise. Some operations required more. For instance, the round trip between Europe and East Asia took at least a year, and Europeans needed agents in Asia to dispose of their cargo and to assemble goods that they could bring home. Merchants also had to negotiate agreements with Asian potentates on access to markets, taxes, and warehousing. No partnership, much less any individual, had the resources—

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financial or human—for all these tasks. When the Portuguese opened direct trade with Asia at the end of the fifteenth century, the government financed and managed the business. In the corporation, the English and Dutch found a superior alternative. Corporations date back at least to the medieval era, when political authorities chartered them for public purposes such as managing schools, hospitals, and local governments. Starting in the late sixteenth century, the English and Dutch began to charter them for business. These organizations pooled the resources of many investors, assembling enough capital for large operations such as trading across routes stretching thousands of miles. To protect shareholders, companies offered limited liability. The potential loss to an investor was limited, usually to whatever he or she had paid for shares. The rules of partnership, in which each principal was liable for the debts of the entire business, could not apply to an organization in which most investors had no say in management and, indeed, rarely knew the managers. These companies were also ongoing enterprises, independent of the lives of managers or investors. The death or retirement of either required not reorganization but simply the appointment of a new manager or the reassignment of the stock. By 1700, the Dutch East India Company dominated the trade between the East Indies (Indonesia) and Europe, while its British counterpart handled the largest part of the commerce between India and Europe. The

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Portuguese found themselves reduced to a minor role in a trade which they had pioneered. The use of corporations in business constituted a major break with tradition. The new British and Dutch companies did usually have some public functions. The Bank of England and its Dutch counterpart helped manage government finances, while the Dutch and British East India companies negotiated trade accords with Asian governments and, ultimately, governed substantial territories. The focus on earning a profit for shareholders represented something new, however, and as with most major innovations, it stirred controversy. Allowing private citizens to earn money from corporations, which traditionally existed to serve the public good, seemed corrupt. Moreover, these organization often enjoyed legal monopolies that aroused resentment among those excluded. The British East India Company, for instance, had the sole right to trade between Britain and India. Many in Britain complained that corporations allowed private interests to hijack government for their own purposes, an idea that resonated among Americans like Thomas Jefferson. What is more, in working out the possibilities and limits of corporations, promoters made more than a few mistakes. The notorious South Sea and Mississippi Company bubbles of 1720, which cost investors dearly, were the most famous such errors. These disasters led France to effectively ban new corporations and Britain to impose the Bubble Act, which required a specific act of Parliament for each new company. Subsequently, the British

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legislature confined new charters largely to enterprises like canals or toll roads that could plausibly claim a public purpose. After securing its independence, the United States abandoned such limits. Though blessed with abundant natural resources, the new republic lacked the capital to develop them. To remedy this deficit, states chartered banks to finance trade by pooling resources and creating credit. By 1800, the United States had twenty-nine incorporated banks, and the number more than doubled over the next decade. With the important exception of the federally chartered Bank of the United States, these institutions operated much like Britain’s private banks, taking deposits, issuing notes, and making loans. After 1815, many of the large textile mills that had sprung up in Lowell, Massachusetts, and other industrial centers in New England also secured corporate charters. Again, they operated much like British textile mills owned by proprietors or partnerships. In neither case did corporations serve any special public purpose. Many Americans opposed the growth of corporations. Presidents Jefferson and Jackson viewed them as instruments of privilege inappropriate to a republic and made opposition to them a centerpiece of their political programs. The fact that each corporation required a specific act by a state legislature lent substance to such charges. Only the politically connected could secure charters, and approval often entailed unsavory backroom dealings. Ironically, such concerns ultimately led to the expansion

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of corporations. Starting in the 1830s, most American states gradually adopted “free incorporation,” granting corporate charters to any who met specific criteria. The states—with a strong push from the federal courts—also stopped giving companies legal monopolies. These changes democratized corporations, putting them within the reach of most entrepreneurs. By 1860, almost all banks and railroads in the United States were corporations, as were many manufacturing and commercial enterprises, though in the latter fields incorporation remained the exception rather than the rule. As corporations expanded, American courts defined them. These organizations, whether managed for profit or not, had always occupied an anomalous position, creations of government that nevertheless operated autonomously. In the 1819 Dartmouth College decision, Chief Justice John Marshall (1755–1835) settled the matter, at least for the United States, when he declared that the corporation is “an artificial person” that could “manage its own affairs and hold property”—effectively divorcing companies from the governments that created them. Yet Marshall’s answer posed new questions. If corporations were, for the purposes of the law, people, how far did their rights extend? In the Dartmouth case, the Supreme Court ruled that a state could not unilaterally alter a corporate charter, but otherwise it left the matter open. The Fourteenth Amendment to the Constitution, approved in 1868, offered clarity. Designed to protect the rights of former slaves, it redefined citizenship. Heretofore, indi-

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viduals had been citizens of their states, and through them the Union. With the Fourteenth Amendment, individuals became citizens of the Union and as such possessed rights that states had to respect. Corporations’ lawyers contended that these artificial persons should enjoy the same protections as did flesh-and-blood people with respect to holding property and enforcing contracts. Though initially quite controversial, by 1890 the federal courts had largely accepted this interpretation. Ultimately, almost every other capitalist society reached the same destination as the United States, though their paths varied, as did some significant details. By the late nineteenth century, most European countries provided for a category of companies that were in effect partnerships with limited liability, a device that remained rare in the United States and Britain. German companies usually had (and still have) two boards, one composed of senior managers and another of distinguished outsiders, with the latter setting overall policy and the former handling operational issues. Nevertheless, almost every jurisdiction allowed “free incorporation” and granted companies the same rights as individuals with respect to property and contracts. With the rapid growth of railroads over the second half of the nineteenth century, corporations took on a new role. Almost as soon as the technology appeared, most observers recognized that railroads would have to incorporate. The expense of building and operating roads with several hundred miles of track was beyond the resources of

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any individual or partnership. Even the fabulously wealthy American railroad barons of the late nineteenth and early twentieth centuries—Jay Gould, C. P. Huntington (1821– 1900), James Hill (1838–1916), and E. H. Harriman (1848– 1909)—rarely owned even a majority of the common stock of the corporations they controlled. The railroads required more than capital, however. Most had several hundred miles of track and every day ran dozens of trains with hundreds of cars and thousands of passengers and packages. Simply avoiding accidents required careful coordination. Guaranteeing that everyone and everything got where they were supposed to be, when they were supposed to be there, while collecting fares from customers and paying employees and suppliers: each represented an extraordinary challenge. Starting in the 1840s, the railroads developed procedures that allowed them to manage these demanding tasks effectively, in the process becoming repositories of knowledge that others could not easily replicate. Such institutional knowledge represents a competitive advantage and helps explain why some companies earn above-average returns for long periods—often decades. Of course, changes in technology and markets can undermine even a strong organization, and sometimes bureaucracies become sclerotic. In most cases, however, corporations that have mastered complex processes enjoy substantial competitive advantages and solid profits. The history of the German chemical companies in the twentieth century demonstrates the importance of insti-

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tutional expertise. Before World War I, they dominated production of organic chemicals, the most technically demanding and profitable part of the industry, making 80 percent of the world’s dyestuffs and enjoying comparable strength in pharmaceuticals and photographic preparations. The Great War was a disaster for these firms. It cut them off from foreign markets for several years, during which new competitors emerged, often armed with patents and facilities seized from the Germans by Allied governments. Recovery began in the 1920s as the German companies reorganized and developed valuable new technologies like high-pressure synthesis and synthetic rubber, but soon the Great Depression and World War II intervened. The latter was even more disastrous than the first war, bringing with it occupation and partition, and ultimately the German chemical companies lost all their assets outside of what became West Germany. Their reputations suffered as well: these companies were integral parts of the Nazi war machine and during the war utilized slave labor on a vast scale, including workers from the Auschwitz death camp. Some of their managers went to jail for war crimes. Had these enterprises been nothing but collections of properties, these disasters would have permanently crippled them. As it was, they were sophisticated organizations of managers, scientists, engineers, and skilled workers with broad experience in developing and bringing to market complex chemical products. In the long postwar boom,

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the German chemical companies prospered mightily, and by the early twenty-first century four of the world’s ten largest chemical companies were German. At first glance, the two great legal changes wrought by capitalism seem to move in opposite directions. On one hand, changes in property law simplified and consolidated ownership, while on the other, business corporations represented a new type of property, often with multiple layers of ownership. Both innovations, however, had the same object, mobilizing and deploying physical assets to secure the highest possible economic returns.

6  UPS AND DOWNS

Stable capitalism is an oxymoron. Entrepreneurs are constantly innovating and in the process reshaping the economic landscape. In 1900, the United States produced roughly six thousand automobiles, but within thirty years output had soared to over four million. This growth created huge fortunes for men like Henry Ford, Alfred Sloan, and Walter Chrysler (1875–1940), attracted thousands of workers to production centers such as Detroit, reshaped broad swaths of the petroleum, rubber, and steel industries, and gave rise to thousands of car dealerships, tire stores, and service stations. Not everyone benefits from change, however. With the growth of the automobile industry, the vast infrastructure devoted to raising, training, feeding, and stabling horses largely disappeared. Automobiles cut sharply into railroads’ passenger traffic, which declined steadily after 1920. Eventually, the ubiquity of cars undermined streetcar and bus companies, rendering most unprofitable. Capitalists are always tearing 85

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down the past to build a better—or at least a more profitable—future. In 1940, A&P was probably the largest retailer in the United States, but by 1960 it had given way to Sears. By 1980, Kmart had taken Sears’s place, and by 2000 Walmart had eclipsed Kmart. A&P, Sears, and Kmart all missed or misjudged significant changes in markets and technology, eventually falling into catastrophic declines. The wreckage of once-successful enterprises litters the landscape of capitalism. Ideally, growing industries replace declining ones, and successful ventures make up for the failures. Between 1910 and 1930, Ford, General Motors, Chrysler, and their many suppliers hired huge numbers of managers, engineers, and workers, attracting people from as far away as Appalachia and the Mississippi Delta. Their expansion helped keep the overall rate of unemployment in the United States low despite the contraction of older sectors such as railroads, coal mining, and textiles. Dynamic businesses do not necessarily expand at the same rate that less robust ones shrink, however. After World War I, Britain’s huge textile, coal mining, and shipbuilding industries all entered sharp declines driven by foreign competition, changing technology, and a long-term drop in world trade. The country’s automobile, chemical, and electrical machinery industries grew fast, but not fast enough to absorb all the workers shed by other sectors. Between the world wars, unemployment in Britain never fell below 10 percent, and at times it ranged far higher. The country’s problems owed a great deal to World War I, which thoroughly disrupted

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international trade and finance, on which the British depended heavily. Yet almost every capitalist economy has significant pockets of stagnation created by the decline of once-vibrant industries. Rapid growth creates a different sort of problem—speculative booms. The right investment, made at the right time, can yield spectacular returns. Those who bought stock in Union Pacific in 1897, General Motors in 1921, International Business Machines (IBM) in 1945, McDonald’s in 1966, or Microsoft in 1987 did very well indeed. Even a relatively modest initial outlay could, in time, fund a comfortable retirement. The prospect of such gains lures entrepreneurs and investors forward. Most entrepreneurs are optimists—the Eeyores of the world rarely launch new ventures—who often imagine that they have hit upon “the next big thing.” A speculative boom usually begins modestly enough, with entrepreneurs identifying a promising opportunity. In the mid-1990s, observers recognized that information technology (IT), particularly the Internet, could transform economic life. Entrepreneurs organized ventures in the field, supported by investors who bought stakes in the new companies. The promise of the technology attracted investors, whose buying drove up the price of IT companies’ stock, generating handsome profits for the entrepreneurs who had launched these ventures. These gains in turn attracted more investors. Financiers catered to this demand by underwriting new companies, some of which had little to offer besides a plausible business plan. Soon enterprises that had never

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earned a profit enjoyed immense market valuations. In 2000, reality intervened. Many speculative enterprises ran out of money and folded, causing investors to recognize that many IT companies were little more than hype. They sold their stock, and falling prices encouraged further sales as investors tried to get out before the value of their securities fell even further. Before the situation stabilized, several trillion dollars had vanished. A variety of mechanisms transmits the problems of specific industries through the larger economy. Workers laid off by industries in decline must reduce their own spending, as do those who lose money when a speculative bubble implodes. Financial markets, however, are the most powerful conduit of economic hardship. Most enterprises depend on loans for working capital, borrowing to purchase raw materials, pay workers, and carry inventory. They repay credits when they make sales, then borrow again to restock. Anything that disrupts this flow of money quickly affects production. Entrepreneurs finance long-term projects such as new products or facilities in part by selling stocks or bonds, and anything that disrupts the market for securities soon cuts into investment. Established firms that slip into decline find that debts incurred in happier years can become crushing. Managers in contracting industries usually retrench and look for new opportunities to deploy idled resources. Retrenchment can reduce costs, but it does not shrink debts, and innovation requires money, which troubled enterprises

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with heavy debts can rarely command. Between the world wars, British steelmakers suffered both from stiff foreign competition and because the sharp drop in world trade had crippled shipbuilders, their largest customers. Most who studied the situation agreed that steelmakers needed to consolidate operations in their most efficient plants and shift to making wire, tubes, and sheets, which enjoyed growing markets. Many steel companies, however, labored under heavy debts contracted when their prospects seemed brighter, making reorganization difficult. With a few exceptions, they limped through the era until mobilization for World War II saved them. In such circumstances, creditors face a difficult choice. They can write down their loans, taking substantial—perhaps fatal—losses, or they can roll over credits and extend new loans to pay interest on the old, hoping that somehow the situation will improve. The latter approach is usually safer in the short run, but it immobilizes resources in unprofitable enterprises and, more often than not, simply delays the reckoning. British steelmakers’ problems reverberated through the economy. Lenders, with large resources tied up in extensive credits to the industry, had to restrict loans to others. The rolling crisis also absorbed much of the time of bank executives, forcing them to neglect other important matters that in the long run offered more promise. The experience of United Steel suggests that a better alternative existed. In the early 1930s, it became the only large British steelmaker to

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declare bankruptcy. Reorganization cut its debts and interest payments, and the company invested much of the savings in its facilities, substantially improving efficiency. Speculative booms create different but equally severe financial problems. During a boom, as prices spiral upward, many borrow to invest, intending to repay once they sell at a profit. This strategy often works for those who leave the market early, but when prices collapse many investors find themselves owing more than their investments are worth. Both debtors and their creditors can face heavy losses, even bankruptcy. Investors, desperate to get out, will sell as fast as they can, intensifying the crash and multiplying losses. Uncertain about the future, lenders will restrict credits and accumulate cash. Financiers with stock and long-term bonds to sell will find markets closed—few investors will immobilize money in such investments while the crisis lasts. The collapse of Caldwell & Co. in 1930 offers a classic example of this process. An investment bank headquartered in Nashville, it grew rapidly in the prosperous 1920s, financing a variety of risky ventures, many of which failed to earn money. The 1929 stock market crash found Caldwell with heavy debts and securities in speculative enterprises that it could not sell, and it declared bankruptcy in December 1930. Its default threw most of the companies it controlled into bankruptcy, and ruined many small rural banks in the South that had deposited money with it. Farmers and merchants in Arkansas found themselves unable to finance planting because of Caldwell & Co.’s

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dubious investments in construction, department stores, and real estate. For three hundred years, entrepreneurs, economists, and public officials have sought to anticipate economic crises and thereby avoid them. But identifying difficulties is easier in retrospect than in prospect. As late as 1920, British steelmakers enjoyed solid earnings and easy access to credit. The collapse came suddenly, with a huge drop in demand in 1921 that turned profitable firms into wards of the financial system. The Penn Central Railroad, the largest in the United States, paid a regular dividend up to the moment it declared bankruptcy in 1970. Until the very end, most observers assumed that the Penn Central’s problems were temporary, the product of adjustments associated with the 1968 merger between the Pennsylvania and New York Central railroads that had created it. On the other hand, companies and even entire industries that appear to be in terminal decline sometimes recover. In the last two decades of the twentieth century, cotton fabric clawed back a significant part of the ground it had lost over the previous generation to synthetic fibers (nylon, polyester). New permanent-press technology reduced the need to iron cotton fabrics; consumers increasingly appreciated the texture of cotton cloth and how it “breathes”; and the industry launched an effective advertising campaign with the slogan “Cotton, the fabric of our lives.” After 1980, railroads in the United States that carried freight, long considered economic dinosaurs, experienced a remarkable revival. The federal government ended most

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regulations, allowing the industry to shed unprofitable businesses and focus on heavy, long-distance traffic— coal, grain, containers—that trains could move more efficiently than competitors. Identifying speculative booms offers different but equally daunting challenges. All new ventures are to some degree speculative, based on a future of which no one can be sure. Bank managers have a rule of thumb that a loan officer who has never had a loan go into default has almost certainly been too cautious. Most speculative booms have a realistic foundation, at least initially. The South Sea Company, the focus of the 1720 bubble that was arguably the first great speculative boom, was a profitable if unsavory enterprise—it dealt extensively in slaves—that would pay solid dividends for decades. Promoters, however, sought to use it to wrest control of the government’s finances from the Bank of England, a risky and ultimately unsuccessful project that raised unrealistic expectations. Many of the companies at the center of the IT boom of the late 1990s were dynamic enterprises with bright futures: Apple, Amazon, Microsoft, Oracle, eBay, and Cisco. The history of capitalism is replete with disasters that never materialized and “sure things” that went wrong. Starting in the early 1980s, financial markets in the United States traded a growing volume of “junk” bonds—obligations paying high interest rates issued by companies with a history of default, particularly heavy debts, or little record as borrowers. From the start, critics predicted an ugly reckoning, but it never came. Anyone

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holding a diverse portfolio of junk bonds since the 1980s has done fairly well, with high rates compensating for the occasional default. Mortgage bonds—securities backed by home mortgages—also expanded rapidly beginning in the 1980s. Most investors considered them gilt-edged because after 1945 defaults on home mortgages were rare, and real estate (houses) backed the loans. After 2000, however, housing prices rose very fast, fueled by easy credit provided by lenders, the federal government, and not least the purveyors of mortgage bonds. The boom unraveled in 2007–8. Buyers could no longer afford inflated prices, and in some markets like Las Vegas, Nevada, and Orlando, Florida, housing construction had far outstripped demand. Prices began to decline, and many homeowners, some of whom had bought houses not as dwellings but to resell later at a higher price, began to default on their mortgages. This development undermined confidence in the value of mortgage bonds, and their value collapsed. Financial institutions holding such instruments not only suffered losses but found that because no one knew the scale of the losses, they could borrow only against gilt-edged collateral. These institutions conducted business on credit, and its evaporation threw many into bankruptcy, creating a severe financial crisis and a long, deep recession. Recognizing the difficulty of predicting the future, many argue for overall restrictions on the expansion of money and credit to limit speculation and the ability of troubled firms to accumulate debt. Defenders of the gold standard contend that by tying money to a commodity

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whose supply is fixed, it imposes such a limit. Monetarist economists, most famously Milton Friedman (1912– 2006), insisted that a slow, steady expansion of money and credit would accomplish the same end. Almost every country requires banks to keep a fixed portion of deposits in reserve and to maintain capital equal to a specific share of total assets, both to limit the expansion of credit and, in a crisis, to provide these institutions with the resources to survive withdrawals and losses. Such measures can make a difference. The collapse of the IT boom in 2000 cost investors trillions, but it did not spark a financial panic. U.S. law capped loans against stock to half its market value—that is, those buying securities with a market price of one hundred dollars had to put up at least fifty dollars of their own money. The collapse of values did not, therefore, lead to widespread defaults on loans. Yet restricting credit is difficult. William McChesney Martin (1906–98), chairman of the U.S. Federal Reserve in the 1950s and 1960s, summed up the problem succinctly when he quipped that the Fed was “like the chaperone who has ordered the punch bowl removed just when the party was really warming up.” No one wants to disturb a boom in progress. Jobs are plentiful, profits high, and getting rich seems easy. Moreover, someone will always have a reason why “this time is different.” Recriminations come only after the crash. In 1966, the Federal Reserve raised interest rates sharply because inflation had accelerated, drawing howls of dismay from those affected, particularly homebuilders. Though unemployment was low

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and growth robust, President Lyndon Johnson (1908–73) harkened to these complaints, turning all of his immense powers of persuasion on Chairman Martin. Martin held out longer than did most against Johnson, but in 1967 the Fed cut interest rates significantly. In retrospect, most economists believe that the United States missed an opportunity to halt, at relatively low cost, the upward drift of inflation that would bedevil it for the next fifteen years. Even if authorities stand firm, borrowers will often evade restrictions. The focus of the 1907 panic in the United States was trust companies, which had expanded very fast because they faced more lenient regulation than banks. The 2008 crash revealed that banks in the United States had created a host of “off balance sheet” entities to evade restrictions on lending. Capitalist societies do better cleaning up after crises than avoiding them. Almost all have three devices that can significantly mitigate downturns. 1. Lender of Last Resort.  A lender of last resort is an institution that holds reserves that it can make available during a financial crisis to banks and other financial institutions under pressure. It is usually the central bank—an organization like the Bank of England chartered by the government specifically to manage its finances and oversee the banking system—though others can play this role. During the 1907 financial panic in the United States, J. P. Morgan pooled the resources of the banking community and deployed them to institutions under pressure, functioning as a one-man lender of last resort.

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The Bank of England pioneered the practice, beginning in the eighteenth century, when it intervened in some crises by lending to those under pressure. The financial panic of 1825, however, represented the turning point. As one bank official put it, to contain the crisis, “we lent it [i.e., money] by every possible means, and in modes that we never had adopted before; we took in stock [government bonds] as security, purchased exchequer [Treasury] bills, we made advances on exchequer bills, we not only discounted outright, but we made advances on deposits of bills of exchange to an immense amount; in short by every possible means consistent with the safety of the bank, and we were not upon some occasions overnice.” This massive injection of money into financial markets resolved the crisis and set a precedent for the future. ­Walter Bagehot (1826–77), a journalist intimately familiar with London’s money market, provided the classic formula for the lender of last resort. “The only safe plan for the Bank [of England],” he wrote in 1873, “is the brave plan, to lend in a panic on every kind of current security.” Such action would not only provide badly needed cash but reassure holders of all securities that they could, if necessary, turn them into money. The latter matters because during a crisis the value of even gilt-edged securities becomes uncertain as buyers evaporate, raising questions about the solvency of those holding such instruments. By making money plentiful and credit available, a lender of last resort can end panic selling. Security prices will stabilize, albeit at a lower level. With a measure of order restored, finan-

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cial institutions can assess their situation, free of the euphoria of the boom or the despair of the crash. Most usually discover that despite losses they are solvent—that is, their assets exceed their debts. Banks will resume lending, and at least some buyers will return to securities markets, looking for bargains. Recovery will begin, although the process usually takes time. Each country has its own history. Napoleon created the Bank of France in 1801 to sort out the financial mess created by the French Revolution. The United States created the Federal Reserve, its lender of last resort, only after the crisis of 1907. By 1950, however, such institutions were ubiquitous. 2. Bankruptcy Laws.  In a financial crisis, a lender of last resort can protect solvent institutions. Unfortunately, it cannot help the insolvent, those whose debts exceed their assets. Bankruptcy law serves their needs. Traditional societies treated bankruptcy as a species of fraud. In ancient Greece and Rome, creditors could sell bankrupts into slavery, and even in the early nineteenth century, creditors in Britain and the United States could consign the insolvent to prison. In a capitalist society, however, such harshness is counterproductive. Entrepreneurs must take risks, and some will fail. Henry Heinz (1844–1919) went bankrupt before starting Heinz Food, and Henry Ford managed two unsuccessful auto companies before launching Ford Motor. Consigning such individuals to debtors’ prison is not in society’s best interest. Starting in the nineteenth century, most capitalist countries devised systems

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that allowed insolvent debtors to cancel their debts by signing over their assets to creditors. Borrowers in less dire straits could stretch out payments, rescheduling rather than writing off obligations. The process soon extended to corporations, with an important variation. Railroads set the precedent. In cases where these organizations defaulted on their debts, courts concluded that their value as “going concerns,” that is, organizations hauling passengers and freight, exceeded the sum of their assets—rolling stock, real estate, and the like. Accordingly, courts put railroads under the charge of trustees, often drawn from current management, who would “write down” the road’s debts to a manageable level. Courts subsequently extended this approach to troubled companies in other fields. The experience of railroads in the United States during the severe 1893–97 depression demonstrates the benefits of bankruptcy. During this disaster, railroads controlling roughly a quarter of the country’s mileage defaulted on their obligations. Those affected included two of the four “trunk” lines connecting Chicago with the Atlantic Coast (the Erie, and the Baltimore & Ohio), three of the country’s five transcontinental lines (the Northern Pacific, the Union Pacific, and the Atchison, Topeka, & Santa Fe), and important regional roads (the Reading, and the Richmond Terminal). During the 1880s, American railroads had experienced a classic speculative boom, laying a staggering ninety thousand miles of new track, much of it financed by borrowing. Each sought to tap underserved

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regions and make key connections before rivals did, and in the competitive frenzy track grew faster than traffic. Many roads found expenses rising faster than revenue, a trend that culminated in the early 1890s in a series of defaults. As roads missed debt payments, bankers, lawyers, and managers sprang into action, putting them under the protection of bankruptcy and commencing reorganization. J.P. Morgan & Co.’s restructuring of the Richmond Terminal constituted perhaps the most complex of these operations, but Kuhn, Loeb’s reorganization of the Union Pacific ranks a close second. The details varied, but all reduced debt payments substantially and provided funds to upgrade facilities. The railroads’ problems had contributed mightily to the depression that began in 1893, and general recovery roughly coincided with railroads’ exit from bankruptcy, with both beginning in 1897. 3. Unemployment Relief.  Though financial reorganization can lay the foundation of recovery, the process takes time that those out of work in a downturn do not have. Unemployment relief bridges the gap. Historically, most societies provide for “the poor,” however defined. The Roman Empire gave free grain to the inhabitants of Rome and, later, Constantinople. Christianity and Islam both enjoin charity on believers, and in societies dominated by these faiths religious institutions provided substantial assistance to the needy. The Industrial Revolution put new burdens on traditional arrangements. The English Poor Law, a product of the Elizabethan era, authorized local boards to levy taxes and provide relief for the poor.

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As the British economy developed, two major weaknesses appeared in the system. First, in hard times the boards had to levy substantial taxes to meet their obligations. Taxes are never popular, particularly when the overall economy is weak. Second, the poor could claim benefits only in the communities into which they were born. Those who moved in search of work—a rapidly growing number—had nothing to fall back on if they became unemployed. This limitation not only excluded many in dire need but discouraged others from moving to find work. Reforms in the 1830s resolved these problems but created new ones. Every jurisdiction erected a “work house” in which those who required assistance would live and work under strict discipline. The object was to discourage applications for relief by making it as degrading and unpleasant as possible, not only saving money but encouraging the improvident to find jobs. In practice, administration varied considerably over time and from place to place, particularly during economic downturns when authorities often resorted to “outdoor relief,” handing out food and money to those in need. Yet the principle that the unemployed were largely responsible for their plight remained enshrined in law until 1911. In that year, Britain instituted unemployment insurance that paid regular benefits to those who lost their jobs. Though initially designed only to tide workers through short-term economic downturns and seasonal shifts in employment, in the 1920s mass unemployment led to a major expansion of benefits. To limit costs, local authorities imposed

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a “means test,” requiring that recipients exhaust their own financial resources before turning to the government. Nevertheless, the law established the principle that the government would assist the needy, and the means test disappeared in the 1940s. By the 1950s, most other capitalist countries had adopted roughly comparable systems, though the history and details of reform varied considerably. Germany, which had established old-age pensions in the 1880s, added unemployment insurance in the 1920s, and France created a roughly comparable system at about the same time. Unemployment insurance came to the United States in the 1930s as part of Social Security. Everywhere, unemployment insurance served two purposes. First, it preserved those who lost their jobs from destitution, allowing them to buy groceries and pay rent. Second, benefits limited any decline in economic activity by allowing the unemployed to purchase basic items and to stay current on their debt payments. Critics of lender of last resort, bankruptcy, and unemployment insurance cite “moral hazard.” If bankers know that they can rely on a lender of last resort in a crisis, they will be less careful in their lending and hold fewer reserves. Bankruptcy can be a shield for fraud. Workers with generous unemployment benefits will refuse wage cuts even when economic conditions dictate, or refuse to move to take a new job. These concerns are not academic. Confident that the government would protect them if

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trouble developed, enterprises in the United States selling mortgage bonds expended recklessly before the 2007–8 crisis. Some allowed their ratio of capital to assets to decline to as little as 3 percent, so that even a relatively small shift in markets could ruin them. For decades, grifters in the United States preferred to operate out of Florida because its bankruptcy laws made it easier for them to shield assets from creditors. There is an inverse relationship between the generosity of unemployment benefits and the willingness of workers to move, even if in the long run other localities offer better opportunities. Yet the danger of abuse is no reason to abandon these remedies. Political authorities simply need to exercise caution. Walter Bagehot, in his discussion of the lender of last resort, insisted, “These loans should only be made at a very high rate of interest,” or what bankers and economists call a “penalty rate.” With cost high, bankers will only borrow when they must and will repay as quickly as they can. The United States limits the duration of unemployment benefits, extending the limit when the economy is weak but returning to the previous rule when it recovers. Some people will always “game” the system, but careful management can keep the problem within bounds. Instability is the price of dynamism. Capitalists are constantly building a new world on the ruins of the old. This process requires that people take risks—not only entrepreneurs but investors and workers in new enterprises. If the penalties for failure are too high, innovation

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will slow or even stop. Solicitude for those caught up in the inevitable downturns of capitalist economies is not only a matter of compassion but one of self-interest. Entrepreneurs are more likely to start a new venture knowing that if it fails, they will find themselves in bankruptcy court rather than debtors’ prison.

7  OFF THE BALANCE SHEET

Capitalist enterprises often impose costs on others. Factories dump waste into rivers and emit smoke into the atmosphere. Workers suffer serious injuries on the job. Products, either because of inherent flaws or mistakes in production, harm consumers. Economists refer to these as “externalities,” and they accrue because of the “tragedy of the commons,” when all have access to a resource but no one has responsibility for it. A plant located on a major waterway incurs no costs from dumping waste into it, even if this action contaminates drinking water. Externalities are not unique to capitalism. In traditional societies, common pastures often suffered from overgrazing, and common woodlands from deforestation. The Soviet Union suffered severe pollution, large numbers of workplace injuries, and flawed consumer goods—Russian televisions had a habit of exploding. Capitalist societies nevertheless have an appalling record in the field. In the early 1900s, the pollution around 104

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Pittsburgh, Pennsylvania, was so severe that observers described the city as “Hell with the lid off.” The Cuyahoga River, which runs through Cleveland, Ohio, was so polluted in 1969 that it caught fire, as did the Chicago River in Chicago and the River Rouge near Detroit, Michigan, at other times. In 1907, roughly twelve thousand railroad employees in the United States died from work-related injuries. Tobacco companies sell products that slowly kill their users. Though the specifics vary, every capitalist society has such horror stories. Worldwide, the burning of fossil fuels, in large part a product of capitalist enterprise, has contributed significantly to global warming—a development with alarming implications. When called to account, entrepreneurs usually respond in two ways. First, they cite the positive externalities of business—jobs created, consumers served. It is rare for the profits of any enterprise to exceed 15 percent of revenue. The rest goes for wages, raw materials, taxes, and the like. In the case of minor externalities, like traffic around shopping centers, this argument resonates. The benefits conveyed by enterprises almost certainly outweigh such costs. Yet unchecked pollution can render air, water, and even soil toxic. Many perish in workplace accidents or because of tainted consumer products. In these cases, the balance is different. Second, many entrepreneurs and economists contend that the capitalist system of property limits externalities. By equating ownership with control, it gives owners the incentive and authority to preserve resources. Most of the extensive forests of the American South are private property. For

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decades, logging was careless, with timber companies cutting trees and moving on. The hot, humid climate of the region allowed forests to recover fairly quickly. By 1945, however, the pace of logging threatened to overwhelm natural recovery, and over the next decade landowners turned to “scientific forestry.” They replanted trees, tended them by maintaining fire breaks and culling, and after twenty years or so harvested forests and started again. Scientific forestry not only improved yields but substantially reduced erosion and runoff and provided habitat for wildlife; overall, the region experienced considerable reforestation. In the Soviet Union, externalities were in part so severe because the state owned everything. In theory everyone was responsible, but in practice no one was. In capitalist societies, the lines of responsibility are much clearer. Nevertheless, the system of private property is no panacea. Air, for instance, is not and cannot become anyone’s property. In many cases, externalities demand regulation. Regulation is a political process reflecting the virtues and defects of the government that executes it. In capitalist societies, entrepreneurs enjoy considerable political influence and have no desire to shoulder new costs. Regulation reflects a constant series of compromises, and some balance competing claims better than others. The 1980 Superfund Act, which sought to clean up toxic waste dumps in the United States, demonstrated the pitfalls. Such cleanups are very expensive, and everyone involved wanted someone else to bear the cost. Congress created a

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complex formula allocating expenses among landowners, past and present, on the basis of how much they had contributed to the problem. Sites designated under the act quickly became the subject of extensive litigation, with endless motions and hearings over who owed what, and progress was glacial. Those cleanups that did proceed usually depended heavily on government funding. Regulation generally falls into two categories. 1. Command and Control.  Traditional societies frequently legislated behavior, and not surprisingly capitalist societies followed suit. During the Industrial Revolution, British factories employed large numbers of children, often in filthy, unsafe conditions. The British Parliament passed the first measure regulating the practice in 1802. It had little impact because lawmakers naively assumed that employers and parents would obey the law, which was not the case. In 1833, however, Parliament created a system of inspections and penalties that rendered regulation effective. Child labor did not vanish—those ten and over could still work long shifts, though not as long as adults— nevertheless, the system significantly mitigated the problem, and subsequent legislation extended restrictions until, in the 1930s, the government completely banned those under fourteen from the workplace. Such regulation can be effective if the object is clear, the rules straightforward, and enforcement honest. Rules requiring air brakes on trains and seat belts in automobiles, banning lead in paint, and imposing fire safety codes on buildings

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all fall into this category and have yielded substantial benefits. Such regulation has limits, however. Welding is certainly dangerous, but companies use it in many contexts. Underwater welding on drilling rigs is quite different from welding by robots on assembly lines. Regulations governing how workers do all these different jobs would be extraordinarily complex, and enforcement even more so. The atmosphere can absorb a certain amount of ordinary smoke without ill effects. A code of dos and don’ts designed to keep emissions below this level for the whole range of businesses emitting smoke would be mammoth and difficult to enforce. 2. Creating Incentives.  Instead of dictating behavior, regulation often creates incentives for enterprises to solve problems on their own. In economic terms, the object is to force them to bear the cost of externalities, so that enterprises base decisions on the full cost of their activities, internal and external. Workman’s compensation, which exists in one form or another throughout the United States, represents an early example of such regulation. Starting in 1911 in Wisconsin, employers had to pay anyone hurt at work, for whatever reason, a sum determined by the severity of the injury. In case of death, the money went to the worker’s estate. This system not only provided workers insurance against injury but gave employers a substantial incentive to improve safety. Welders who work fast but are careless become a potential liability.

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The 1991 Clean Air Act in the United States applied this approach to air pollution. Among other things, it addressed “acid rain,” which was damaging forests and poisoning lakes in eastern North America. Acid rain was the product of sulfur dioxide emitted by power plants and industrial facilities like steel mills. The 1991 act capped sulfur dioxide emissions at a relatively low level and gave each polluter the right to emit a certain volume of it, a right they could buy and sell. Those able to cut sulfur dioxide emissions without too much trouble, say by switching to low-sulfur coal, did so, selling their rights to others less well situated. Government had only to monitor emissions to make sure they were in line with permits. Discharges of sulfur dioxide soon fell to the point where acid rain ceased to be a major problem, and did so at relatively low cost. Regulation often works. By the early twenty-first century, child labor was a thing of the past in North America, Western Europe, and Japan outside of small family businesses or farms. By the same time, workplace fatalities in the United States had fallen to about six thousand a year—half the total on railroads alone a century earlier. Thirty years after the Cuyahoga River caught fire, kayakers were paddling down it. The Chicago River, once an open waste dump, hosted cruises for tourists eager for scenic views of the city and its architecture. Just as every capitalist society has its horror stories, so too each has its triumphs.

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Many environmentalists, taking their lead from the Club of Rome, contend that capitalism’s success is ephemeral. It relies heavily on fossil fuels and other finite resources, generates toxic pollutants whose impact on the environment no one fully understands, and most alarming, has initiated global warming, which threatens to destabilize weather patterns and inundate low-lying regions. Metaphorically, capitalist societies have been eating their seed corn, and humanity must reorient economic development to make it “sustainable.” Entrepreneurs, however, are always seeking to do more with less and have an extraordinary record of overcoming limits if, in so doing, they can earn a profit. A famous wager placed in 1980 encapsulates the broader issue. It involved Paul Ehrlich (b. 1932), a biologist who had long predicted that rising population would overwhelm natural resources, and Julian Simon (1933–98), an economist skeptical of such warnings. They chose five commodities, with Ehrlich betting that over the next ten years rising demand driven by higher population would force their prices up, and Simon that their costs would fall as entrepreneurs identified substitutes, exploited new supplies, and reduced consumption. Simon won: the prices of all five commodities declined. Entrepreneurs, working through markets, had transcended limits that Ehrlich considered immutable. Capitalism is always redefining the possible. In the eighteenth century, British iron masters substituted coke for charcoal in blast furnaces, con-

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serving scarce timber. In the nineteenth century, entrepreneurs turned petroleum from a vexing sludge into the world’s most valuable commodity. In the twentieth century, the Haber-Bosch process broke the nitrogen cycle, which had limited agriculture for millennia. The challenge is not to move beyond capitalism but to harness its capacity for innovation to resolve problems like global warming.

8  THE RANK AND FILE

Before the modern era, capitalists devoted little thought to labor. Even merchants doing business across thousands of miles rarely employed more than a handful of warehouse workers and clerks, at least some of whom were usually family. The expansion of capitalism in early modern Europe gradually altered the situation, but change was slow. In most cases, capitalists became major employers only with the Industrial Revolution. When capitalists did turn to the workplace, they brought a new attitude to it, constantly reorganizing it to maximize economic profit. Entrepreneurs showed little patience for the traditions that governed peasant agriculture and urban workshops. The revolution in cotton textiles entailed not only developing new machinery but deploying it in factories, where managers could make sure that workers kept the new devices in regular use and maintained them properly. The assembly line represented another innovation in the workplace, as did the complex 112

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bureaucracies railroads created to coordinate the flow of traffic. Broadly speaking, traditional societies had organized labor in three ways—serfdom, slavery, and wage labor. Serfs were attached to the land, having the right to farm it but owing obligations to a landlord. They could not move, and children inherited their parents’ station. Other­ wise, their condition varied immensely. In medieval Europe, serfs were in effect perpetual tenants, and at least some were fairly prosperous. In nineteenth-century Russia, serfs were little better than slaves. Either way, serfdom accorded poorly with capitalism. It tied workers to the land in a relationship that changed only slowly. Capitalism entails constant redeployment of economic resources, including land and people, in search of higher profit. The disappearance of serfdom from Western Europe by 1500 was undoubtedly a key factor in the subsequent expansion of capitalist enterprise there. From an early date, most observers recognized that economic development required a flexible labor force. When Japan and Russia launched ambitious development programs in the 1860s, both began by abolishing serfdom. Slavery and capitalism have had a more complex relationship. Almost every traditional society had slavery, although its importance varied. Slaves were a minor part of Europe’s labor force in the High Middle Ages but absolutely central to the economy of ancient Rome. Unlike serfdom, slavery can exist profitably within capitalism. Though slaves required a substantial initial investment—employers had to

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purchase slaves outright whereas they paid wage labor week to week—they were flexible: owners could move slaves hundreds or even thousands of miles and reassign them at will to different tasks. Slavery had particular strong appeal in the Americas, where labor was scarce but opportunities great. Starting in the sixteenth century, European entrepreneurs used African slaves to cultivate lucrative sugar plantations in the Caribbean, and English settlers in North America followed suit, using slaves to grow tobacco, rice, and after 1790, cotton for the rapidly growing textile industry. During these years, the Atlantic slave trade expanded manyfold, earning large profits for both European and African slavers who, over three centuries, tore roughly ten million Africans from their homes to labor in the New World. Sugar and cotton plantations, as well as organizations like the South Sea Company that dealt in slaves, were among the largest enterprises of their day. During the nineteenth century, a remarkable change occurred. Responding to a shift in opinion first evident in the late eighteenth century, European governments and the United States abolished first the slave trade and then slavery itself. Economic considerations had little direct influence on these decisions. Opposition to slavery developed most rapidly in Britain, which had probably gained more from the institution than any other country. The Caribbean sugar industry went into decline only after the ban on the slave trade restricted the supply of workers, and the cotton plantations of the American South were profitable right up until the Civil War. Rather, Europeans

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and Americans gradually concluded that slavery was morally unacceptable. Opponents of slavery did often insist that it was economically inefficient. At its simplest, this argument was wrong. The Caribbean and the American South were quite prosperous—though slaves, of course, saw little of this wealth. Yet the history of the United States between independence and the Civil War does offer strong evidence that wage labor allowed for faster economic development than slavery. In 1790, the country was evenly divided between slave and free states. With the important exception of slavery, their social and political structures differed little. By any reasonable standard, the southern states did well economically over the next seventy years. In two generations, planters pushed from the Atlantic tidewater into Texas, bringing vast stretches of land under cultivation to provide cotton for the rapidly growing textile mills of Britain, New England, and continental Europe. Slaves farmed these plantations, but many whites followed the advancing frontier, carving out numerous small farms whose crops fed the region. Southern entrepreneurs moved quickly to exploit new technologies such as steamboats and railways. Manufacturing lagged, but the region did possess some iron works and textile mills as well as a large population of skilled artisans, many of whom were slaves. By 1860, per capita income in the region was higher than that of any European country except Britain, even if slaves are included in the calculation. Nevertheless, the free states did even better. By 1860, their people too had pushed

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beyond the Mississippi River and had built up a large export trade in flour, which they ground in automated mills. The region had a manufacturing base second only to Britain’s that produced large quantities of the most sophisticated products of the day—locomotives, steam engines, and machine tools. The North boasted twice as much railroad track as the South over a comparable area. Most striking, the population of the North grew much faster than that of the South. Neither region lagged—the United States expanded from four million in 1790 to thirty-one million in 1860. Yet whereas in 1790 the populations of the two regions were about equal, by 1860 twothirds of the country’s people lived in the free states. In addition to rapid natural increase, the North absorbed a huge wave of immigrants from Ireland and Germany during the 1840s and 1850s, many of whom were desperately poor. This influx, roughly two million, would have destabilized many societies, but northern entrepreneurs found jobs for these people. Despite the rapid increase in population, per capita income in the North was at least as high as that of the South, and probably a little higher. Two factors can explain the better performance of the North’s system of wage labor. First, slaves had little incentive to take the initiative. Competent planters knew how much work a person could perform in a day and usually extracted it from their slaves. Yet a slave rarely anticipated problems, much less devised solutions for them, because good performance earned no raise and weak performance did not risk dismissal. Slaves had an incentive to work

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just hard enough to avoid punishment. Free workers, by contrast, are always making minor adjustments to improve efficiency and quality. In the nineteenth century, workers making devices with interchangeable parts, like sewing machines, often needed to file parts to make them fit. Slaves, however, had no stake in the success of what they made, and no overseer could supervise such detailed work. Certainly, no one in the South considered deploying slaves in such industries. Slave craftsmen—carpenters, blacksmiths—were the exception that proves the rule. Owners usually hired out such people and allowed them to retain some fraction of the proceeds, giving these slaves an incentive to do good work quickly. On average, they were as efficient as their free counterparts; still, most slaves lacked such incentives. Second, slavery limited the size of the market. The system was profitable because owners could, in effect, confiscate slaves’ earnings above subsistence. The intelligent owner provided slaves with adequate food, clothing, and shelter because they were valuable property, but provided little more. In the nineteenth century, however, entrepreneurs would build large enterprises selling soap, chocolate, cigarettes, beer, newspapers, housewares, readymade clothes, canned food, and much more to workers. Smaller enterprises like restaurants, bars, theaters, and stores catered to the same customers. Slavery effectively blocked these avenues of development. In practice, capitalist enterprise usually depends on wage labor. In an ever-changing economic environment,

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employers want to hire and fire workers as needed, and for their part workers want to take advantage of new opportunities. Wage labor is ancient, but capitalists have used it on an unprecedented scale. Observers as diverse as Karl Marx (1818–83) and Thomas Carlyle (1795–1881) considered wage labor synonymous with capitalism—an understandable exaggeration. For the first time in history, the well-being of the great mass of the population depended not on the harvest or the conditions of tenancy but on the labor market. Labor markets surpass all others in complexity. Unlike grain or coal, workers have their own wills and wants that have nothing to do with economics. One person will refuse a job at higher pay to remain close to family, while another will accept lower wages for the opportunity to travel. Moreover, the labor market is actually many markets. Pharmacists rarely compete with electrical engineers. Often changes that help one part of the workforce hurt another. The development of industrial robots created new opportunities for workers familiar with computers but eliminated many assembly-line jobs. In the early nineteenth century, most economists believed that workers faced a grim prospect. The ideas of Thomas Malthus (1766–1834) framed the issue. He theorized that from generation to generation, population increased faster than the resources available to support it, so that population growth tended to consume any surplus and push living standards toward subsistence. David Ricardo (1772–1823), a friend of Malthus, offered a slightly

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less depressing prognosis. If commerce and manufacturing grew fast enough, he believed, wages might rise above subsistence. That was but one possibility, however, and Ricardo considered other outcomes at least as likely. The competition between workers for jobs tended to depress wages, and he believed that improvements in productivity could, by cutting the demand for labor, actually reduce pay. Karl Marx worked out such ideas in the greatest detail. Put (very) simply, he believed that capitalism would ultimately choke on its wealth. The system prospered by extracting surplus value from workers, holding wages down while improving efficiency. In the long run, workers would not be able to buy all they produced, and unsold output would accumulate, producing a crisis. Capitalists would respond by cutting costs—particularly wages—and consolidating their operations, but though such measures could resolve the immediate problem, they intensified the long-term trend. Sooner or later, Marx theorized, this process would culminate in economic collapse and political revolution. Few other economists shared Marx’s apocalyptic vision, but many accepted that an “iron law of wages” pushed workers’ income toward subsistence. Between 1800 and 1850, experience seemed to confirm these predictions. The living standard of workers in the first industrial nation, Britain, was quite low. During periods of prosperity wages would edge up, but frequent recessions knocked them back down. The situation in industrial districts elsewhere in Western Europe and in the United

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States does not seem to have been much better. In New England, the rapid growth of textile production forced down both prices and wages, and women tending looms in the 1840s earned less than their counterparts in the 1820s. Studies of the physiology of workers between 1800 and 1850 suggest that they became, on average, smaller—a sign of declining nutrition. The second half of the century, however, saw a great change. Between 1850 and 1900, the real wages (purchasing power) of British workers increased by 50 percent. Though the details varied, workers in the United States and Western Europe saw roughly comparable gains. This trend challenged conventional economic thinking, and it flatly contradicted Marx. Marginal analysis, developed by William Jevons, Carl Menger (1840–1921), and Leon Walras (1834–1910), offered an explanation. Economists such as Adam Smith (1723–90), Malthus, and Ricardo understood that the forces of supply and demand “cleared” markets, bringing production and sales into equilibrium, but they could not explain why markets settled on a specific price. Marginal theory answered this question, predicting that supply and demand would balance when the cost of producing one more unit of a good equaled the benefits consumers reaped from having one more unit. This analysis explained a variety of counterintuitive phenomena. Diesel fuel sometimes commands a higher price than gasoline even though it costs less to refine. Diesel engines, however, produce more power per unit of fuel, so consumers will pay more for it. The implications for labor

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markets were profound, upending previous assumptions about the subject. The marginal benefit of labor is its productivity, so if productivity increases, employers will value labor more highly and be willing to pay workers more. In economic terms, higher productivity shifts the demand curve for labor up. In 1914, Henry Ford astounded the business world by announcing that henceforth Ford Motor would pay all workers on its new assembly lines five dollars a day, an unprecedented sum for unskilled labor. Ford asserted that he wanted to share the company’s huge profits with workers and give them the income to purchase the cars they made. Company records suggest another motive, however. The frantic pace of Ford’s assembly line created heavy turnover among workers—a major problem for an organization that depended on thousands of people working in unison. Ford and his associates hoped that the five dollar wage would stabilize the workforce because employees could not earn nearly as much anywhere else. Ford’s humanitarian impulse was genuine, but it accorded with economic calculation. Other factors can neutralize the impact of higher productivity on wages. Between 1800 and 1850, real wages in Britain stagnated despite large advances in industrial productivity. During these years, the country’s population increased 150 percent. Though manufacturing grew rapidly, agriculture still employed more, and the productivity of farms was not growing as fast as that of factories. Urban employers could attract all the workers they needed ­simply by offering wages slightly higher than those paid

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agricultural laborers. In economic terms, growing population shifted the supply curve for labor down. It is probably no accident that workers’ real income began to rise only after 1850, when the number of Britons living in towns finally surpassed those residing in the countryside. In the late twentieth and early twenty-first centuries, the world as a whole had a comparable experience as roughly four hundred million Chinese migrated from farms to factories, where they produced goods that flooded world markets, holding wages down everywhere. Though uneven, the material progress of workers in capitalist societies has been astounding. In the early nineteenth century, unskilled workers in Western Europe and North America worked sixty hours a week or more to earn only a little more than subsistence. Tea and coffee were luxuries, and meat more so. In the early twenty-first century, almost all homes in Europe and North America have indoor plumbing, an amenity lacking in Louis XIV’s opulent palace at Versailles. Hundreds of millions carry smartphones, giving them access to far more information than was available in the great Library of Alexandria. At the same time, the average work week has fallen to about forty hours. As economist Joseph Schumpeter wrote, “The capitalist achievement does not typically consist in providing more silk stockings for queens but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort.” This material cornucopia has a price. In traditional societies, labor is communal. Peasants work alongside

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family and neighbors for common ends, as do many craftsmen. Common agreement determines schedules, and all understand the purpose of their labor. Such is not the case with capitalist enterprise. Most have little control over the workplace, clocking in and out at fixed times and doing tasks assigned by others. The assembly line represents the epitome of this tendency, with workers performing one task at a regular interval all day long. These systems are very efficient, but they can be dehumanizing. Not only can the work be numbingly repetitive, but because it represents only a very small part of a larger process, its ultimate purpose is obscure to workers. A job becomes little more than a paycheck. Marxists refer to this condition as “alienation.” It explains why, in capitalist societies, so many start and maintain small businesses, even though they might well enjoy a higher income and more security working for a large organization. The attraction of “being your own boss” outweighs such considerations. Though significant, alienation is neither universal nor crippling. Even in the largest companies, executives, professionals, and engineers usually have challenging work and broad responsibilities. The manager of a department store must answer to superiors, but he or she is nevertheless in charge of dozens of people and many lines of merchandise, and may enjoy a broad field of activity. Many enterprises—though by no means all—have sought to reduce alienation, using the ideas of management experts like Peter Drucker (1909–2005) and W. Edwards Deming (1900–93), who contended that workers engaged in their

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jobs are more conscientious and efficient. In the early twenty-first century, most assembly lines allow anyone along the line to stop it to fix a problem—something Deming introduced. This practice not only gives workers more responsibility but offers tangible proof that the assembly line is subject to them, not the other way around. Many assembly lines also rotate workers between different positions, giving their jobs more variety. Experience strongly suggests that such efforts do reduce alienation and improve both efficiency and quality. In capitalist societies, the workplace is not synonymous with society. The traditional village encompassed all social relationships, and alienation from it was disastrous. Guilds operated in much the same way. Capitalist society is more diverse and less centralized. Those who consider their jobs little more than a paycheck—something endured to cover expenses—may nevertheless enjoy a rich family and social life and contribute to their communities in a meaningful way.

PA R T 2   C A P I TA L I S T S O C I E T Y

Capitalism is an economic system, not a political, religious, philosophical, or aesthetic one. Individual entrepreneurs have opinions on these subjects, but there is no such thing as capitalist art or religion. Even in politics, entrepreneurs rarely present a united front unless the rights of property or the sanctity of contracts is at stake. Capitalist development nevertheless profoundly affects other fields. Economic life is central to every society, and the changes wrought by capitalist development radiate outward. The results are usually unintended but profound nonetheless.

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9  UNDERMINING HIERARCHIES

By creating wealth in new and often unexpected places, capitalist development threatens the existing social order. Riches are a species of power, and any society that pursues capitalist development must accommodate wealthy outsiders or risk creating a permanent class of powerful dissidents. Traditional societies, however, are usually tightly knit hierarchies, hallowed by experience and justified by religion or philosophy. Change is difficult. Throughout most of recorded history, the group defined the individual. The vast majority had a clear place, usually decided by birth, that determined occupation, legal rights, and the choice of a mate. Position carried obligations to both superiors and inferiors, further dictating behavior. Most believed that society functioned best when all played their allotted roles. Up to a point, these arrangements reflected reality. Most individuals were peasants, living in communities with only a small surplus. Prosperity—sometimes even survival—demanded that each perform his or 127

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her assigned task. Peasant villages also had to present a united front against landlords and tax collectors eager to appropriate their surplus, and individualists, by creating holes in this front, posed a threat to all. The gentry’s power rested on its ability to carry out its political and cultural responsibilities and to uphold widely accepted values. Those who refused these responsibilities or challenged these values, like Socrates (c.470–399 b.c.), undermined the entire class. Urban guilds followed these precedents. Anyone who ignored the rules, like the Danzig ribbon-maker who devised a more efficient loom, damaged others’ prospects. Social order reflected a series of delicate compromises among these interests, creating what some historians call a “moral economy,” which reflected political realities and social values as much as economic conditions. The ideas of philosophers like Confucius and Aristotle (384–322 b.c.), who postulated natural hierarchies based on mutual obligation, both accorded with and ratified these systems. Traditional societies differed from each other in significant ways. The Hindu caste system was particularly rigid, viewing social mobility as blasphemous. Classical China was more flexible, offering at least a few opportunities for the ambitious and talented to rise. Medieval Europe had two hierarchies, one secular and one religious, each with its own priorities. Hinduism and medieval Islam accorded merchants fairly high status, while classical China viewed commerce suspiciously. Despite variations, these societies were all hierarchical, and barring some large external shock they changed only slowly.

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Capitalist development challenges these systems. Britain, one of the first capitalist societies and the first industrial nation, faced the challenge early. Late in the seventeenth century, British merchants with modest backgrounds began to accumulate large fortunes in trade with India and the Caribbean. On returning home, they purchased country estates and sometimes obtained seats in Parliament. Denunciations of these “Nabobs,” as they were known, became a staple of British politics from the mid-1700s. Supposedly, Nabobs had no sense of tradition, and because they owed their elevation to acquired wealth rather than inheritance, they were by definition corrupt. Nevertheless, the newcomers quickly settled into power and produced offspring who played a major role in British politics. William Pitt the Elder (1708–78), William Pitt the Younger (1759–1806), and Lord Liverpool (1770–1828), who between them served as prime minister for over thirty-five years in the late eighteenth and early nineteenth centuries, all counted Nabobs among their ancestors. Capitalism also rearranges the population. During the Industrial Revolution, huge numbers of workers left the British countryside for the cities, leaving villages where their ancestors had dwelt for centuries. In the process, they cut long-standing ties with family and community that had shaped their lives, and entered a new, largely unformed world. Parish churches, usually presided over by a priest selected by a local landowner, had long occupied a central place in rural life. Britain’s industrial centers, however, lacked the countryside’s pastoral infrastructure, and to the

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extent that workers attended services at all, they were as likely to frequent Methodist chapels as to join congregations of the Church of England. As German industry developed in the second half of the nineteenth century, Protestants and Catholics from the countryside, who had lived separately for centuries, found themselves working side-by-side in cities. This process manifested most dramatically in the United States, whose cities drew—and still draw—immigrants from all over the world, throwing together dozens of ethnic and religious groups with little in common besides jobs in American enterprises. The forces that create new industries and fortunes can also work in reverse. In 1900, the British textile industry employed well over half a million and sold its products throughout the world. A century later, the industry had largely disappeared, a victim of competition from foreign companies with lower wages and newer plants. The vast network of companies, banks, and markets that had constituted the industry vanished, along with the professional and trade associations and labor unions linked to them. Those once employed in textiles, or their descendants, had to find other work, often in other places. The elite is not immune to these shifts. Capitalism is in no sense egalitarian—it spreads wealth widely but not evenly. The promise of outsized fortunes, and the power and prestige that go with them, drives entrepreneurs forward. Capitalist development does, however, constantly redistribute wealth. In the late nineteenth century, many in the United States feared that those who dominated the

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railroads—Cornelius Vanderbilt, Collis Huntington, Jay Gould, James Hill, and E. H. Harriman—would establish a new aristocracy based on their control of the chief arteries of transportation. Certainly these men enjoyed great wealth and power, both of which they sometimes abused. Yet it did not last. Economic shifts around 1920, particularly the growth of the automobile industry, led to the eclipse of the railroads and the families whose wealth rested on them. These people did not fall into penury, but they gradually lost the power to move society. As Karl Marx wrote in one of the most perceptive passages of his Communist Manifesto: “All fixed, fast-frozen relationships, with their taint of ancient and venerable prejudice and opinions, are swept away, all new-formed ones become antiquated before they can ossify. All that is solid melts into air.” Under such pressures, the moral economy of traditional societies crumbles. It depends on social relationships that no longer exist. What Thomas Carlyle called the “cash nexus” of the market replaces it. Markets can adjust rapidly to change because participants respond to economic incentives rather than social expectations. Critics such as Carlyle found this shift alarming because it substituted self-interest for social obligation, creating the specter of moral anarchy. Defenders of the new order, however, insisted that individuals who pursued their own interests in an environment characterized by free markets and private property served the general good. As Adam Smith wrote in The Wealth of Nations, “It is not from the

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benevolence of the butcher, the brewer, or the baker that we expect our dinners, but from their regard to their own interests.” Capitalism turns the values of traditional society upsidedown, making a virtue of instability and self-interest. Individuals can define themselves—the past does not necessarily determine the future. In his Autobiography, Benjamin Franklin (1706–90) described how he rose from a penniless runaway to one of Philadelphia’s leading citizens and an internationally respected scientist thanks to ability, hard work, and virtue. This volume provided the inspiration for countless strivers in the English-speaking world, and some beyond it. Lawyer and banker Thomas Mellon (1813–1908) wrote in his own autobiography how, as a child, “I happened upon a dilapidated copy of the autobiography of Dr. Franklin. It delighted me with a wider view of life and inspired me with new ambitions. . . . Here was Franklin, poorer than myself, who by industry, thrift and frugality had become learned and wise, and elevated to wealth and power.” Widely read authors like Samuel Smiles (1812–1904) and Horatio Alger (1832–99) would further popularize the “self-made man.” Educator and civil rights leader Booker T. Washington (c.1856–1915) insisted, “Success is to be measured not so much by the position one has reached in life as by the obstacles which he has overcome.” Whereas traditional societies judged individuals by how well they performed their allotted roles, capitalist societies evaluate individuals by the degree to which they have transcended their origins.

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No capitalist society is entirely, or even predominately, capitalist. The most driven entrepreneurs usually have friends, pursue hobbies, and occasionally meditate on philosophy and religion. Such activities are part of the fabric of traditional society, but not of capitalism. In capitalist societies, individuals satisfy these impulses through what social scientists call “civil society”—the dense network of religious denominations, charitable foundations, fraternal orders, professional associations, reform movements, labor unions, sports leagues, book clubs, and the like. These organizations are voluntary, and for the most part membership in one neither precludes nor requires participation in another. An individual might worship in a Methodist church, support the Republican Party, belong to the YMCA, attend meetings of the Rotary, lead a den of Cub Scouts, and sing in a barbershop quartet. Like capitalism itself, civil society is constantly changing with the interests and views of the population. Bowling leagues, ubiquitous in the United States in the 1950s, faded, while book clubs multiplied in the early 2000s. New organizations appear, established ones alter their focus, and old ones fold, shadowing capitalism’s permanent revolution. Traditional societies were usually quite suspicious of such organizations, viewing them as centers of dissent and often suppressing them. Roman authorities distrusted early Christians, in part because congregations met in private and had their own rituals. As late as 1600, European scientists had no societies or journals through

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which to circulate their findings. Civil society grew in tandem with capitalist development. By 1700, the Royal Society, the product of an increasingly capitalist Britain, offered scientists a forum in which to publicize their ideas. Over the next century, voluntary organizations like Methodist chapels and Masonic lodges multiplied in Britain, and by the middle of the nineteenth century the country counted hundreds of independent organizations devoted to every purpose imaginable. If possible, the United States had even more of these. Most of these organizations emerged more or less spontaneously, often through the efforts of those with modest means. Junior clerks working in London created the YMCA in the 1840s. Occasionally, organizations rooted in traditional society reinvented themselves. The Catholic Church clung stubbornly its privileged position for a long time, but with the 1891 encyclical Rerum Novarum it began to reconfigure itself as part of civil society, a process largely completed by the Second Vatican Council of the 1960s. The most powerful institution in traditional Europe had become the largest single organization in civil society. Together capitalism and civil society have tremendous appeal. They liberate individuals from inherited constraints and allow them to find their own place. Even those who adhere to tradition, following the example of their forebears, choose to do so. The abolition of slavery testifies to the power of these ideas. Historically, slavery has existed in almost every society, though its scale varied. A few small groups like first-century Judean Essenes

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and seventeenth-century English Quakers refused to own slaves, but they were peripheral. More typical were thinkers like Aristotle and Confucius, who defended slavery as part of the natural order, though they did insist that masters had moral obligations to slaves. Capitalists accepted the institution as well, exploiting African slaves on a huge scale to develop the Americas. The abolition of slavery owed to shifting moral currents. If hierarchies are natural, then justifying slavery is not difficult. The institution simply codifies the inevitable subordination of some, and its cruelties are an unavoidable part of life, like disease. If, however, society is a collection of individuals who in pursuing their own interests serve the community as a whole, then slavery takes on a very different aspect. The 1774 Somerset decision embodied this new thinking. In it, Britain’s Lord Chancellor, Lord Mansfield (1705–93), concluded that slavery was contrary to natural law and so could exist only if established by positive statute. Since England had no such law, any slave who set foot there automatically became free. In fact, philosophers and political thinkers had held for millennia that slavery was part of the natural order, and England had always contained at least a few slaves, statute or no. Lord Mansfield drew on a more recent tradition, pioneered by thinkers like Thomas Hobbes (1588–1679) and John Locke (1632–1704), that considered society a contract among individuals. No one, Mansfield reasoned, would consent to being enslaved, so the institution could not be “natural.” Ascribing political

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and legal principles to economic conditions presents a variety of problems, all the more so in the case of capitalism, which has little intellectual content. Mansfield, however, spent much of his time on the bench standardizing English commercial law. He was not only acutely aware of capitalist development but intimately involved in it, and the values it fosters are among those that animate the Somerset decision. Capitalist development did not dictate the abolition of slavery, but it created an environment in which abolition became conceivable. Capitalism and civil society are not identical. The movement to deprive capitalist slaveholders of their human property was the product of civil society, as are labor unions and socialist parties. Yet capitalist development creates the space in which civil society grows, and civil society addresses subjects that capitalism ignores. The two are part of a whole.

10  THE SEARCH FOR LEGITIMACY

By constantly reorganizing society, capitalist development poses a grave threat to political order. Stable governments possess legitimacy. The large majority accepts that the authorities have a right to power, even when they disagree with specific policies. Regimes based purely on force can prosper for a time, but they are brittle, without the reserves to survive adversity. Genghis Khan’s (c.1162–1227) Mongols deployed overwhelming force, but the moment their subjects were strong enough to expel them, their empire collapsed. In traditional societies dependent on peasant agriculture and dominated by social hierarchies, governments usually drew legitimacy from two sources. 1. Divine Sanction.  Egypt’s pharaohs claimed to be gods, as did Rome’s emperors. Islamic caliphs considered themselves heirs of the Prophet Mohammed (571–632), while European monarchs asserted the “divine right of kings.” Such rulers emphasized their authority by participating in religious rituals and maintaining temples and 137

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sanctuaries as well as by upholding religious values, at least in public. 2. Representation.  Other governments claimed to em­ body the communities they ruled. The republics of the ancient Mediterranean world—Rome, Athens, Carthage, Sparta, and others—balanced various interests. In Rome, aristocrats dominated the Senate, while the Tribunes protected the rights of ordinary citizens. In medieval and early modern Europe, a dense network of assemblies and collective rights served the same purpose. Such regimes did not provide equal treatment—even in democratic Athens, slaves and women had no say in government. Rather, they reflected society as it was and assumed the moral authority to act on its behalf. Many governments combined both types of authority. In the Roman Republic, office holders had religious as well as secular responsibilities. While claiming divine right, European monarchs often ruled through representative institutions such as the British Parliament and the Spanish Cortes. Classical China merged these two sources of legitimacy particularly effectively. The official ideology, Confucianism, imagined a society based on mutual, though unequal, obligations that the state had a responsibility to maintain. A government that did so had the “Mandate of Heaven,” which manifested in spiritual equilibrium, natural balance, and social harmony. Traditional polities were usually quite conservative. Institutions had the sanction of experience and reflected deeply held values. When confronted by a serious prob-

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lem, both the population at large and intellectuals often blamed leaders’ moral failings and departures from tradition. Facing a novel challenge, officials would rush to the archives in search of relevant precedents. Societies did adjust to change, but the process was difficult. The Roman Republic conquered a huge empire in the third and second centuries b.c., but it retained the institutions of a city-state, which proved unequal to governing its new possessions. Corruption metastasized and ambitious leaders used the resources of the provinces to destabilize the politics of Rome itself, a process that culminated in three bloody civil wars in the first century b.c. The greatest political thinker of the era, Cicero (106–43 b.c.), insisted that the republic could save itself only by returning to its traditional values and practices. Though an experienced politician as well as a learned scholar, he could not accept that new circumstances might require institutional reform, and may not even have considered the possibility. By stubbornly resisting innovation, the republic’s defenders guaranteed its collapse. Augustus (63 b.c.–14 a.d.) ultimately ended civil strife by imposing a dictatorship and devising new mechanisms to govern the empire. He did so, however, under the fiction of restoring the republic, of which he claimed to be but the first citizen. Despite decades of political failure, the republic still possessed legitimacy that Augustus dared not ignore. Because it entails constant change, capitalist development undermines traditional sources of legitimacy. New industries grow as established ones decline; people take

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new jobs and move to new communities; new centers of wealth and power develop—not once but constantly. No regime, however constituted, can reflect such a protean society. In 1700, Manchester was a modest town in the English countryside. By 1800, it was well on its way to becoming the center of the world’s textile industry, with a population of over 75,000; yet it lacked not only representation in Parliament but many of the rudiments of municipal government. Change undercuts religious authority as well. Capitalist development frequently allows religious minorities to accumulate wealth and power. Excluding them from political life risks creating a permanent, powerful class of dissidents, but granting them full rights will compromise the government’s religious character. As opponents of Jewish emancipation in nineteenth-century Europe observed, no regime which granted Jews full equality could claim to be Christian. Political authorities in traditional societies instinctively resisted making concessions. Political change, they feared, would only compound social instability and hasten the decline of the government’s authority. Klemens von Metternich (1773–1859), the dominant figure in the Austrian Empire from 1809 to 1848, epitomized such intransigence. He firmly believed that the erosion of traditional institutions would lead to political chaos, such as had engulfed France after the 1789 revolution. His regime tolerated economic development but suppressed political dissent. A gifted politician, Metternich held the line for decades, but in 1848 revolutions in Germany, Hungary, and Italy drove

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him from power. This upheaval eventually petered out, allowing existing regimes to survive with only a few concessions, but it convinced many that in the long run reaction was untenable. Well before 1848, Britain had embarked on a different path. The first industrial nation, it had to deal with the political challenges of capitalist development before any other country. In this process it enjoyed two significant advantages. Since the Glorious Revolution of 1688, Britain had been a constitutional monarchy—a species of republic. Politics revolved around building coalitions and compromises, and leaders paid attention to public opinion, though it was rarely decisive. This system was far more flexible than the monarchies that governed most of the rest of Europe. Second, Britain’s elite contained a significant leavening of merchants, or their descendants, and much of the gentry ran their estates as capitalist enterprises. They did not simply observe capitalist development but participated in and profited from it. For them, the new order was as much an opportunity as a threat. Between 1815 and 1914, Britain gradually transformed itself into a democracy. The 1832 Reform Act, which reapportioned Parliament and enfranchised the middle class, constituted perhaps the most important step in this process. Driven by intense popular pressure, this reform made the middle class an equal partner with the gentry in government and moved Britain several steps from oligarchy toward democracy. Other measures extended political equality to religious minorities, gave the franchise to most

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adult men, democratized local government, and emasculated the House of Lords. In 1914, the government still retained many of the forms of traditional society—monarchy, established church, and aristocracy—but its substance was democratic. With a few exceptions, the architects of Britain’s new system were conservatives who believed that they were shoring up the regime, not revolutionizing it. They recognized the declining authority of traditional institutions and believed that concessions to democracy would strengthen the political system. This attitude represented something new. In traditional society, conservatism meant opposing innovation. Concessions to irresistible pressure might be inevitable, but they represented, at most, a necessary evil. British conser­ vatives certainly revered tradition and refused to consider change simply because existing arrangements fell short of some philosopher’s ideal. Yet they recognized that changing conditions often required reforms that, executed judiciously, could actually strengthen inherited institutions. Philosopher and politician Edmund Burke (1729–97) laid out this approach formally in his writings in the late eighteenth century, and it characterized the attitudes of nineteenth-century British statesmen as diverse as Lord Liverpool, Robert Peel, Benjamin Disraeli (1804–81), William Gladstone (1809–98), and Lord Salisbury (1830–1903). The British backed into democracy. Most of the country’s leaders saw it as merely one element of an evolving political system, not as the central principle. Democracy nevertheless possessed great advantages. Its basic unit is the

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individual, who expresses preferences through regular elections. Between such contests, citizens are free to discuss political issues, agitate for change, and create organizations to contest elections. Open, honest elections convey legitimacy because the victors can claim to represent the population—at least for the time being. This focus on the individual allows democracy to withstand the permanent revolution capitalism unleashes, because no matter how much society changes, individuals remain. Elections reflect the structure of society at the time, and as society evolves so will the electorate—and the governments it puts in power. Democracy does not simply represent the political face of capitalism. Marx’s famous assertion, “The executive of the modern state is but a committee for managing the common affairs of the whole bourgeoisie,” is nonsense. Even if we count commercial farmers and independent proprietors and their families, capitalists have probably never constituted more than 10 percent of the population of any country. Wealth gives them disproportionate influence, but it does not guarantee victory at the polls. Democracies frequently pursue policies contrary to the desires of entrepreneurs, and in a few cases—Britain in 1945 and France in 1981—they have elected socialist governments committed to capitalism’s demise. Capitalism and democracy have a marriage of convenience. The former needs political stability to thrive, but the changes it unleashes will undermine most regimes. The latter has no ready-made economic program and appreciates the wealth capitalism

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generates. Frequent quarrels mar the relationship, but in the end both sides usually conclude that they are better off together. Nationalism offers capitalist societies another organizing principle. The sentiment is of long standing. The ancient Egyptians, Babylonians, and Assyrians probably possessed a sense of nationalism, and the ancient Greeks and Romans certainly did. By 1500, the English, French, Japanese, Koreans, Vietnamese, and others thought of themselves as distinct peoples. Each imagined itself as a sort of extended family with a common temperament and outlook manifested in their nation’s history, culture, and institutions. The ancient Greeks considered themselves individualistic, almost to the point of anarchy, and their political system, which consisted of many independent city-states, often in conflict with one another, reflected this quality. Around 1800, nationalist sentiment gained strength in Europe while becoming more abstract. It put heavier emphasis on national character, a people’s “genius,” while downgrading institutions and history. In many cases, the latter actually obscured the former. After the 1789 revolution, many French nationalists decided that their country was destined to free Europe from the shackles of feudalism, even though France itself was the creation of its monarchs, who had formed it over centuries from the western part of Charlemagne’s (742–814) empire. In particular, each nation needed its own state to realize its potential. In the case of countries like France and England, which had a long tradi-

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tion of centralized political authority, such claims were not jarring. Italy, however, had not been united politically since the sixth century, and the German government, the Holy Roman Empire, was a collection of autonomous realms and had been for centuries. Explaining such intellectual shifts is difficult, not the least because ideas have a power of their own, independent of circumstances. The first stirrings of capitalist development, which posed a challenge to traditional institutions, probably played a part. Contemporary political developments certainly had a role. Poland disappeared in the late eighteenth century, carved up by its neighbors, against whom the chaotic Polish state could not offer effective resistance. Patriots everywhere concluded from this experience that if a nation was to preserve its unique qualities, it needed a strong government. The popularity of William Hegel’s (1770–1831) philosophy, which saw the state as the culmination of human endeavor, both reflected and accelerated the shift toward a more abstract nationalism centered on a strong government. This new type of nationalism could withstand capitalist development precisely because it was so abstract. A regime that successfully identified itself in the popular mind with the nation’s “genius” enjoyed legitimacy independent of specific social arrangements. Yet this strength contained a weakness. A nation’s genius rarely included a blueprint for government. Various groups positioned themselves as their nation’s defenders, trying to shape nationalism according to their own convictions and selfinterest—a process that yielded very different outcomes

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in different countries. In Britain, parliamentary democracy became identified with the nation, and in the United States a less centralized version of democracy did the same. In France, supporters of the monarchy and of the 1789 revolution defined the nation quite differently, contributing mightily to the country’s chronic political instability in the nineteenth and twentieth centuries. Only in the 1960s did Charles de Gaulle (1890–1970) merge these disparate strands of nationalism in his Fifth Republic. In Germany, Otto von Bismarck (1815–98), the chief minister of the country’s largest state, Prussia, united the country under Prussian leadership. He created a system of government dominated by Prussia’s traditional elite—the monarchy, army, bureaucracy, and gentry (Junkers)—who assumed the mantle of German nationalism. Though these groups dominated the new regime, Bismarck accepted entrepreneurs, and the middle class in general, as long as they resigned themselves to being junior partners. In the late twentieth and early twenty-first centuries, the Chinese Communist Party cast itself as the nation’s defender, a message that resonated more strongly with the population than did communism. The result was the odd spectacle of an ostensibly communist regime pursuing capitalist development under the aegis of nationalism. Nationalist regimes must adapt to changing social and economic circumstances, but they possess no adjustment mechanism comparable to what democracies have in regular elections. Sometimes nationalist leaders conclude

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that because they represent the nation, which is eternal, they need not worry about ephemeral change. Francisco Franco (1892–1975) of Spain embodied this attitude. He possessed a romantic image of Spain as a nation of priests, crusaders, and conquistadores, and he decried newer elements, particularly those with foreign ties such as Freemasons and communists, as the “Anti-Spain.” After winning a vicious civil war in the 1930s in which his forces crushed liberals, socialists, communists, anarchists, and regional separatists, he established a regime that made few concessions to those who did not fit his image of Spain. Even entrepreneurs found themselves marginalized, though most had supported Franco in the civil war—albeit often more from fear of the communists and anarchists than out of enthusiasm for him. In the late 1950s, his regime did launch a program of economic liberalization that yielded substantial gains for capitalists, but it was a response to a severe economic crisis that had created food shortages, not an effort to broaden the government’s basis of support. Not surprisingly, Franco’s regime did not long outlive him. Nationalism gives governments the moral authority to deal with social change, not the luxury of ignoring it. The government organized by Bismarck did better, accommodating other interests while retaining ultimate power in the hands of traditional elements. Tariffs, imposed in 1879 to protect German farmers and their Junker landlords from foreign competition, also applied to imported textiles, iron, and steel, benefiting industrialists

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in those fields. Most notably, in the late 1880s the German government created a system of pensions and disability insurance for workers, inaugurating the modern welfare state. At the time, and since, many of Bismarck’s critics considered his system unstable and believed that only a politician of his extraordinary talents could keep it running. Yet it continued to work well enough under Bismarck’s de facto successor, Kaiser William II (1859–1941), who had little of his predecessor’s political talent. William’s downfall was diplomacy and World War I, not domestic politics. The German home front actually held up quite well during the war, collapsing only after military defeat became inevitable. The legitimacy of nationalist regimes that preside over capitalist societies will ultimately crumble if they fail to adjust to changing circumstances—but that does not make such failure inevitable. Nationalism no more represents the political face of capitalism than does democracy. Entrepreneurs do often view nationalist parties and regimes as bulwarks against socialism and communism. In 1973, most of Chile’s business class supported Augusto Pinochet’s (1915–2006) overthrow of the elected government of communist Salvador Allende (1908–73). Pinochet’s regime subsequently pursued economic liberalization, substantially benefiting the country’s entrepreneurs. Yet nationalism has its own dynamic. Francisco Franco preserved entrepreneurs’ property and quite possibly their lives during the Spanish Civil War, but he offered little more. German business-

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men like Hjalmar Schacht (1877–1970) and Fritz Thyssen (1873–1951) supported Adolf Hitler’s (1889–1945) rise to power in 1933 only to discover, as the new regime consolidated itself, that the Nazis intended to subordinate private enterprise to the state and the Nazi Party. The defeat of Hitler’s regime in 1945 found both men in concentration camps.

1 1   FA I T H A N D C R E D I T

Even religion cannot evade the influence of capitalist de­velopment. Historically, religion often defined society. Ancient Sumerians believed that each of their cities was the property of a god who, in exchange for sacrifices, protected it. Most ancient cities had such divine protectors—­Marduk for Babylon, Assur for Ashur, Malqart for Tyre, Athena for Athens, Diana for Ephesus. Medieval Europeans thought of themselves as citizens of Christendom, a society united in its loyalty to the Catholic Church. Though not so tightly organized, Muslims also considered themselves part of a community of faith governed by Sharia, religious law. The Hindu caste system represented the extreme conflation of society and religion, with believers attributing the caste into which an individual is born to his or her virtue—or lack thereof—in previous lives. Though the official ideology of classical China, Confucianism, was a moral phi­ losophy rather than a religion, it possessed many of the trappings of the latter, with officials performing various 150

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rituals and claiming the “Mandate of Heaven” to justify their authority. Because religion was so central to society, conflict over it could easily degenerate into violence. Athenian authorities killed Socrates for encouraging doubts about their gods. The Roman Empire persecuted Christians because they rejected inherited religion and, worse, refused to worship the emperor. Medieval and early modern European Christians burned heretics alive. A dispute between Sunni and Shi‘ite Muslims over who should have succeeded the Prophet Mohammed has kept the two groups at odds—and often at war—for over thirteen hundred years. The Protestant Reformation sparked a series of extraordinarily vicious wars in sixteenth- and seventeenthcentury Europe. When members of different faiths did live alongside each other, complex codes usually governed their interaction. Agreements settling conflicts between Protestants and Catholics in Europe, like the Peace of Augsburg and the Edict of Nantes, contained detailed provisions about who could worship where under what conditions. For centuries, Jews living in Christian and Muslim societies faced a variety of restrictions, not only on their religious observances but on almost every aspect of life. Capitalist development undermines religious stability in several ways. 1. Elevating Unbelievers.  Capitalist development allows religious outsiders to accumulate wealth and the power that goes with it. Indeed, such minorities often enjoy an

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advantage in this process, because facing restrictions in established fields, they eagerly pursue new opportunities. European Jews usually could not purchase land or join guilds and so gravitated toward trade and money lending, putting them in a position to profit from capitalist development. Most famously, in the nineteenth century the Rothschilds, German Jews, created London’s and Paris’s largest investment banks. The pioneers of the British textile and iron industries included many Dissenters, Quakers, and Unitarians who did not belong to the established church and so could not hold public office or send their sons to Oxford or Cambridge. In France, the austere Protestant entrepreneur became a common trope. As Russia began to develop economically in the late nineteenth century, many of its leading entrepreneurs were Armenians, ethnic Germans, or Jews. Society cannot indefinitely relegate people with wealth and power to its margins. It must either accommodate them—diluting its religious character—or sharply restrict their activities, slowing or even halting economic development. 2. Migration.  Capitalist development constantly reshuffles the population, pulling people out of established communities and throwing them together in new configurations. Throughout the nineteenth century, British economic development drew large numbers of Irish Catholics to London, Birmingham, Liverpool, Manchester, and other cities. The growth of German industry in the second half of the nineteenth century threw Catholics and Protestants from the countryside together in

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urban centers like Berlin, Hamburg, Essen, and Dusseldorf. The cities of the United States drew, and still draw, immigrants of almost every faith. Early in the twentyfirst century, the United States counts almost as many Jews as does Israel and more Catholics than Italy. Even when the religious configuration of the population does not change, moving can make a difference. During Britain’s Industrial Revolution, workers relocated from the countryside, where parishes were central to the community, to cities, where the number of churches and clergy did not keep pace with the growth of population. 3. Creating New Practices.  The divine is eternal, and to have a lasting relationship with it, society must rest on eternal truths. Nothing about capitalism is eternal save the search for profit. Some points of conflict are obvious. Islam and the Catholic Church both prohibited charging interest on loans, yet money markets are synonymous with capitalist development. Continuous-processing technologies, like blast furnaces, require that some workers remain at their posts through religious festivals and daily prayers. Other points of friction develop unexpectedly. Capitalism has little to say about the status of women per se, but capitalist enterprises will, if economically advantageous, employ women, allowing them to establish a measure of independence from their families. Any change in the relationship between the sexes will profoundly affect society, inevitably drawing the attention of religious authorities. They are usually uneasy with anything that weakens family structure and sometimes conclude that removing women

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from the home threatens the divine order. Nothing in the late twentieth and early twenty-first centuries provoked the ire of Muslim fundamentalists more than changes in the status of women. Even relatively small matters can stir controversy. Some eighteenth-century American clergymen complained that the introduction of lightning rods short-circuited divine retribution. Religious authorities cannot avoid these issues if they want to preserve the relationship between society and the divine, and they often find themselves playing a game of divine Whack-a-Mole, issuing a constant stream of rulings on innovations large and small. Each decision invites resistance from those who claim a superior understanding—and someone always claims a superior understanding. The process can quickly become stultifying. In 1864, the Catholic Church issued the Syllabus of Errors, which denounced almost every major social, political, and intellectual development of the previous century and a half, including religious toleration and republican government. The church was foolish to reject in toto changes that in many cases had become embedded, even in predominately Catholic societies like Belgium, France, and southern Germany, and its action handed the church’s critics a powerful weapon while locking it into a struggle that it was unlikely to win. Most capitalist societies avoid these pitfalls by embracing “freedom of conscience.” Martin Luther (1483–1546) based the Protestant Reformation on “justification by faith,” arguing that each individual had to forge his or her own relationship with God. Institutions like the Catholic

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Church might facilitate or obstruct this process, but in themselves they had no power to save or damn. This idea had been present in Christianity from the start, but Luther gave it new emphasis, using it to deny the Catholic Church a monopoly on salvation. Subsequently, the ideas of Luther and other Protestant divines like John Calvin (1509–64) spread across Europe. Protestants frequently seized the levers of power and imposed their ideas on the whole community, but just as often they found themselves outnumbered by Catholics and the object of savage persecution. In the latter case, they championed “freedom of conscience.” If salvation depended on an individual’s relationship with God, they contended, then coercion was pointless. It might enforce observance but could not create faith, which was the foundation of religion. A Protestant might consider his neighbors’ Catholicism unfortunate, but it did not threaten his own salvation. Over the course of the seventeenth century, the Netherlands and Britain gradually adopted freedom of conscience. The Netherlands’ eighty-year war of independence from the Spanish monarchy (1568–1648) and the English Civil War (1642–51) both had a vital religious dimension, and in their wake the two countries sought a religious settlement that offered peace. Largely Protestant, they fell back on freedom of conscience. Under the new dispensation, all faiths were not equal. The Dutch Reformed Church and the Churches of England and Scotland enjoyed the support of government, and only their members could hold public office. Religious minorities enjoyed freedom of worship,

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however, and restrictions on members’ activities outside the political sphere gradually faded. Social interaction across sectarian lines remained rare, but it did occur. This system not only allowed Britain and the Netherlands to accommodate the religious strains of capitalist development but also made them the destination of choice for immigrants fleeing religious persecution elsewhere. In 1789, the new United States took the process one step further, formally separating church and state. For centuries, Europeans had considered religion the foundation of moral, social, and political order. Much as the British and Dutch approved of religious toleration, most also supported their established churches. In the United States, however, no religious denomination had anything close to a majority, making the establishment of a national church impossible. The legal equality of all religions was more than a concession to circumstances, however. Most of the founders of the new republic, influenced by radical European thinkers, firmly believed in the separation of church and state. As president, George Washington (1732–99) made a point of attending services at a different church every Sunday. He never worshiped in a synagogue, but in a famous letter to a congregation of Jews in Rhode Island, he wrote that the United States afforded to “all persons alike liberty of conscience and immunities of citizenship.” Over the course of the nineteenth century, most capitalist countries followed the American example, in substance if not always form. After the 1789 revolution, the French government attacked the Catholic Church, sparking mas-

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sive uprisings that threatened the new regime and led to appalling violence—an example that naturally encouraged caution elsewhere. Most found the British example more congenial. In the late 1820s, it granted full political equality to all Christians, and in the 1850s it extended similar privileges to Jews and by implication all non-Christians. At the same time, Britain retained its established church. This approach provided some consolation for members of the latter and preserved the principle that political power had religious sanction, while in practice granting religious minorities full equality. Freedom of conscience does not banish religious conflict. Denominational boundaries remain among the foremost fault lines in every society. In the 1870s, Bismarck waged the Kulturkampf, asserting the German state’s control over the Catholic Church within the country and ultimately suffering one of his few political defeats. The Dreyfus Affair dominated French politics from the late 1890s to 1906, pitting the army and the Catholic Church against the defenders of Alfred Dreyfus (1859–1935), a Jewish officer falsely accused of espionage. During the 1920s, the United States saw the meteoric rise and decline of the Ku Klux Klan, which equated “100 percent Americanism” with Protestantism. Anti-Semitism was, and is, a perennial of European politics. Education offers a particularly fertile source of conflict—coercing faith may be impossible, but teaching it is another matter. Religion has colored much of the discussion of education policy. Rather than banishing conflict, freedom of conscience allows people of

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faith to “agree to disagree.” If society as a whole must have a relationship with the divine, there is no ground for toleration. The authorities must crush religious dissent or at least confine it to the sort of ghettos occupied by Europe’s Jews in the medieval and early modern periods. Freedom of conscience offers a formula that avoids religious war or persecution, and most of the time capitalist societies seize it.

12  THE BUSINESS OF ART

Art reflects the society that creates it. Traditional societies were hierarchical and usually revolved around a central principle, be it Roman virtue, Confucian order, or Christian piety. Their art paid respect to these values. The Iliad and Beowulf embodied the ethos of the aristocratic warriors who dominated early Greek and Anglo-Saxon society, and the Aeneid, written during the reign of Augustus, depicted the origins of the Roman state in heroic terms. The Pyramids emphasized the divinity of the Pharaoh, and medieval cathedrals glorified the Catholic Church. Great art transcends its origins—modern readers still enjoy the Iliad and the Aeneid. Nevertheless, it is hard to imagine a Greek from the eighth century b.c. writing the Aeneid or a Roman from the first century b.c. producing the Iliad. As traditional societies changed, so did their art. Christian motifs were quite rare in Roman art before the conversion of Emperor Constantine (272–337), but they become ubiquitous thereafter. Sometimes art itself drove change. 159

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Ferdowsi’s (c.940–1020) Shahnameh, the Persian Book of Kings, contributed mightily to the revival of the Persian language and by implication Persian nationalism, both of which the Arab conquest of the seventh century had submerged. Traditional art did not always fall into neat categories. Painters, sculptors, and architects sometimes copied foreign devices simply because they found the motifs aesthetically pleasing. Love poems were ubiquitous. Yet traditional authorities were usually ambivalent about art that did not fit into the broader social context. Conservative Romans like Cato the Elder (234–149 b.c.) found the interest of some of their countrymen in Greek philosophy and art appalling and tried, unsuccessfully, to stamp it out. Augustus exiled the poet Ovid (43 b.c.–18 a.d.) from Rome because he considered Ovid’s work salacious. Jewish and Christian authorities have wrestled for millennia with the “Song of Songs,” a sensual love poem that is a book of the Old Testament, trying to convert it into an allegory of one sort or another. In contrast, capitalism has no aesthetic content—the idea of a capitalist opera or poem is ridiculous. Instead, art is a part of civil society. Most cities have museums, theaters, and symphonies, and these institutions invariably count prominent entrepreneurs among their chief benefactors. Some of these people have a genuine interest in the arts. Henry Clay Frick (1849–1919) and Andrew Mellon (1855–1937) appreciated the paintings by Italian and Dutch masters that they collected and with which they ultimately endowed museums. In other cases, capital-

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ists support the arts to enhance their prestige—in capitalist societies, support for such activities helps define “community leaders.” In neither instance is the support for the arts an extension of entrepreneurs’ business interests. Often the initiative comes from below. The organizers of choral groups, community theaters, and crafts fairs are rarely wealthy or prominent. They want an outlet for their interests. In most cases, the individual results are small— sponsors of such events usually consider a turnout of a few hundred a great success. Collectively, however, the impact is great. The American Association of Community Theaters, for instance, counts about seven thousand member theaters staffed by over one million volunteers that play to a combined audience of about 7.5 million annually. Popular culture demonstrates the complex relationship between capitalism, civil society, and the arts. The Elizabethan theater represented an early example of this phenomenon. Acting companies, such as the one to which William Shakespeare (c.1564–1616) belonged, usually did have noble patrons of the sort who had supported art throughout recorded history. These, however, offered political protection, not money. Most municipal authorities considered theaters bawdy, violent, and an invitation to idleness and disorder, and they would shut down playhouses unless some powerful outsider prevented them. Acting troupes paid their bills by selling tickets to members of the middle and working classes. Most writers and actors no doubt thought of themselves as artists, but they succeeded or failed according to how the public received their work.

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The growth of income, first among the middle class and eventually among workers, created immense opportunities for entrepreneurs, some of whom turned to the sale of art. They relentlessly exploited new technologies—the printing press, etching, the rotary press, the phonograph, motion pictures, radio, television, and more—to sell to the masses. For the first time in history, an artist could become rich, though entrepreneurs usually earned even more from art than did artists. In the early twenty-first century, media companies like Disney rank among the largest, most profitable in the world. Many of the entrepreneurs in these industries care passionately about what they sell, but for others, retailing art is no different from selling soap or candy. Regardless, the measure of success is commercial, not aesthetic. Ever since Shakespeare’s day, critics have assailed popular culture. They claim that it appeals to the public’s baser instincts, inevitably degenerating into a “race to the bottom.” Others warn that it allows clever entrepreneurs to manipulate the public. The first complaint has validity. In addition to Hamlet, Macbeth, and Julius Caesar, Shakespeare wrote Titus Andronicus, which begins with human sacrifice, ends with cannibalism, and contains worse in between. Sex and violence sell, as Elizabethan and Jacobean playwrights well knew. Yet popular culture also produced the novels of Charles Dickens, the music of Louis Armstrong, and the movies of Alfred Hitchcock. It gives voice to the masses, for both good and ill. The second criticism reflects a basic misunderstanding of marketing.

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Entrepreneurs certainly try to influence consumers, cultivating critics and deploying advertising, but the public ultimately decides. Hollywood executives still shudder at the memory of Ishtar and Heaven’s Gate, expensive films with famous stars and prominent directors that were critical and commercial disasters, and they marvel at Star Wars, a medium-budget film featuring then-unknown actors, which with its many spin-offs earned billions of dollars. Success depends on divining the public’s taste and catering to it. Like capitalism itself, popular culture is constantly changing, and ultimately it owes responsibility only to the market. Identity is a dialogue between the individual and society. Traditionally, the conversation is one-sided. Society assigns an identity, and only the strongest personalities can break free of it. Even then, the cost is usually high— Romans who in the first and second centuries converted to Christianity lost friends, status, and sometimes their lives. Individuals in capitalist societies have far more opportunities to define themselves, a process in which art plays an important role. Those who listen to punk rock or attend the opera proclaim themselves as rebels and sophisticates, respectively. At the same time, many pursue “art for art’s sake.” The accountant who makes jewelry in her spare time, exhibiting and (maybe) selling it at craft fairs, is simply taking pleasure in the act of creation—itself a quiet statement. This immense diversity is, indirectly, the product of capitalism and its conjoined twin, civil society.

13  THE DILEMMA OF TRADITION

Capitalist development began in a small corner of the globe. By 1850, it predominated only in the western half of Europe and those parts of North America and Australia settled by people from there. In these areas, capitalism had evolved over several centuries, building on existing structures. It was new, but not alien. Not so elsewhere. China, India, and the Middle East all had wealthy merchant capitalists, but their reach did not extend very far into agriculture or manufacturing. Perhaps most important, these regions lacked financial markets. In the second half of the nineteenth century, when their governments borrowed they did so in Europe because they lacked the financial infrastructure to raise money at home. By traditional standards, these regions had sophisticated economies, but they were not poised for capitalist development. The rest of the world could not ignore capitalist development, however. It created immense wealth and rapid technological advances that not only gave capitalist societies 164

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economic advantages but translated into military power. Already by 1760, the British had made themselves the strongest power in India. Even in areas where Europeans had not as yet showed interest in military conquest, like Africa, their trade had transformed economic and political life, strengthening some regimes and undermining others. Traditional societies responded to the challenge in three ways. 1. Isolation.  Some of the most sophisticated traditional societies pursued a policy of isolation. Confident in their own accomplishments and strength, they doubted that the outside world had much to offer. That was certainly the attitude of China’s Qianlong Emperor (1711–99), who in 1793 refused Britain’s request to establish more extensive commercial relations. Even if trade offered profit, it entailed social and political risks, promising to create new centers of wealth and to bring foreigners into the country. Better simply to avoid contact. Starting as early as the sixteenth century, China, Korea, and Japan all pursued policies of isolation, limiting European merchants to only one or two ports and restricting contact between their own people and foreigners. Though debatable, this attitude is certainly understandable. These countries all had rich, venerable cultures that capitalist development would severely disrupt. In the long run, the success of isolation depended on the forbearance of capitalist powers. Capitalist development created military power on a scale that traditional societies—even one as vast as China—could not match. If someone can seize what they want by force without too

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much trouble, there is a good chance they will. Such was the case with the Assyrians, the Romans, and the Mongols, and it is also true of capitalist powers. In the late 1830s, the British defeated China in the First Opium War, forcing it to admit imports on a generous basis and to allow foreign merchants and missionaries to settle in coastal cities. China’s efforts to reverse this verdict twenty years later, in the Second Opium War, resulted in another resounding defeat and further concessions to foreigners. In the 1850s, the Japanese, concluding that they had little choice, negotiated a similar opening of their country to foreign trade and in general abandoned isolation. The Koreans held out until the 1880s, when explicit threats from European powers as well as Japan forced them to abandon isolation. 2. Accommodation.  Traditional societies, when confronted by capitalist ones, will often import technologies and techniques while preserving their basic structure and values. After its defeat in the Second Opium War, the Chinese government followed this course. It opened regular diplomatic relations with the European powers, used the expertise of British officials to stabilize its finances, and imported foreign technology—chiefly weapons but also some innovations with peaceful applications like steamboats. The Chinese regime, near collapse in 1860 because of a series of massive insurrections, had by 1870 defeated its domestic opponents and laid the foundation for a generation of relative peace and prosperity. Accommodation had strict limits, however. China built very few

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railroads despite the recommendations of foreign advisers and the willingness of Europeans to provide capital and equipment. In part, Beijing calculated that construction would require it to borrow abroad, giving foreign powers even more leverage. This fear was not academic. European nations and eventually the United States and Japan would sometimes intervene in other countries to collect debts. Nevertheless, China probably could have built a rail net comparable to what the British constructed in India without assuming unmanageable obligations. Such a program would have improved transportation, lifting the economy as a whole and further uniting the country while encouraging the development of supporting industries like coal mines and machine shops and providing a training ground for Chinese managers and engineers. The country failed to act because railroad projects would have disrupted the balance of power between the central government, provincial authorities, and the gentry. Beijing imported technology to strengthen Chinese society and the existing regime, not to destabilize them. Steamboats, which simply accelerated river traffic, were acceptable, but railroads, which would reorder the economic system, were not. Unfortunately, the country was still no match for the capitalist powers. In 1894, the Chinese found themselves at war with Japan, which had instituted a radical program of development— the Meiji Restoration—and the Middle Kingdom suffered a humiliating defeat that encouraged a new round of intervention by foreign powers.

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Whereas military defeat forced accommodation on China, some other societies, eager for trade with capitalist powers, embraced it. Beginning in the sixteenth century, the states on the African coast that provided European merchants with slaves pursued this strategy, as did Native American tribes like the Iroquois that, starting in the seventeenth century, supplied the French and British with furs. These societies invested part of their profits in imported weapons that allowed them to strengthen their hold over the slave and fur trades. The process did not lead to capitalist development. Traditional arrangements were quite sufficient to maintain and even expand trade, and European powers assiduously courted these states to secure commercial advantage. In such cases, accommodation seemed to offer the best of both worlds, allowing societies to retain most of their traditions and culture while tapping into the wealth capitalism offers. Their position, however, endured only as long as the commodity they offered re­mained in demand. In the early nineteenth century, the European powers and the United States banned the slave trade, and at about the same time, changing fashion in Europe severely depressed the demand for furs. In short order, the exporters of slaves and furs found themselves relegated to the economic and political margins. This outcome was particularly disastrous for Native Americans, who lost their commercial leverage just as settlers from the United States surged west. Accommodation had yielded substantial benefits for a long time, but it left practitioners at the mercy of forces over which they had no control.

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In the early twenty-first century, oil-producing states like Saudi Arabia occupy a similar position. As the suppliers of a vital commodity, they enjoy great wealth, which they spend in part on weapons to preserve and expand their power. These societies have not for the most part embraced capitalist development because oil revenue makes such a wrenching change unnecessary. Should the capitalist world’s thirst for petroleum abate, these states will go the way of the Iroquois. 3. Capitalist Development.  In a few cases, traditional societies have embraced capitalist development. Japan represents the first successful example of such a transformation. In the 1850s, it abandoned 250 years of isolation and opened itself to foreign trade and contacts. At first, its government—the shogunate—pursued a program similar to China’s, importing technology on a limited scale to shore up the existing regime. In 1868, however, a group associated with noble houses long marginalized by the shogunate staged a coup d’état subsequently known as the Meiji Restoration. In theory, they returned to the emperor authority usurped centuries before by the shoguns, but in fact they established something new. Soon after seizing power, some of the coup’s leaders departed on an extended tour of North America and Europe. What they saw convinced them that if Japan wished to preserve its independence, the country had to embrace radical change. They began by abolishing feudalism, including the shogunate, and giving peasants title to the land they farmed while compensating landlords with government bonds. In quick

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succession, they set about organizing a strong army, creating a powerful central state, establishing a system of universal public education, and drafting modern commercial and criminal codes, all with the help of foreign experts. To secure legitimacy for the new order, the Meiji oligarchs cultivated Japan’s already strong sense of nationalism, reimagining the country as an extended family under the benevolent guidance of a semidivine emperor. These changes encountered resistance that culminated in a massive uprising by former samurai in 1877, but thanks to its modern army the regime survived. Ultimately, a constitution modeled on the one Bismarck created for Germany provided a framework for government. It concentrated power in the bureaucracy but also contained significant democratic elements, in particular an elected legislature. The Meiji oligarchs put great emphasis on economic development. They had no master plan but simply supported Japanese enterprise whenever possible. The new Ministry of Agriculture encouraged producers of silk, one of the country’s chief exports, to adopt new technology that substantially improved productivity and quality. The regime built railroads that although short, carried heavy traffic, and it subsidized domestically owned shipping lines, most notably NYK. The government chartered the Bank of Japan and other banks to provide a stable currency and to finance trade and industry. It also founded a handful of state-owned enterprises, chiefly in textiles and mining, using imported technology. Almost

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all lost heavily, and in the 1880s Tokyo sold these firms to private investors at low prices. The new owners turned losses into profits by adapting foreign technology to Japanese conditions, notably tapping into the country’s large supply of cheap, unskilled labor. Success begot expansion, and by 1900 Japan had the beginnings of an industrial base. Just as important, the country had developed a class of entrepreneurs who proved adept not only at seizing opportunities but at creating them by modifying foreign techniques and technology to Japanese conditions, and eventually by devising their own innovations. The Meiji program was an extraordinary success. By the early twentieth century, Japan had an efficient government and legal system, a powerful army and navy, and a dynamic capitalist economy. In the imperialist frenzy that gripped East Asia in the 1890s and early 1900s, Japan was predator, not prey. In the 1930s, Japanese nationalism took an extreme turn, to the profound misfortune of its neighbors and itself. The errors of their grandchildren, however, should not obscure the accomplishment of the Meiji generation. Although not unique, Japan’s success was unusual. Only a few countries outside capitalism’s European heartland and the areas of European settlement have made the same transition. Observers have sought explanation for Japan’s success in its history, especially its experience over the centuries in adopting ideas and technology from China, Korea, and even early modern Europe. Yet three short-term factors stand out. First, the Meiji oligarchs

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began by overthrowing the shogunate. In sharp contrast with the officials of China’s Qing dynasty, they had little stake in the order they inherited. Second, Japan faced a real, long-term foreign threat. One of the Western powers probably would have reduced it to a dependency or even annexed the country had not the Meiji reforms made it indigestible. Reformers could realistically identify their program with Japan’s strong sense of nationalism even though it challenged many of the country’s traditions. Third, by touring the United States and Europe soon after they had seized power, the Meiji oligarchs gained an understanding of capitalist development that no encounter with an American or British warship could offer. They recognized the difference between its artifacts and substance. Notably, the most successful examples of capitalist development in the second half of the twentieth century, South Korea and Taiwan, faced conditions similar to Japan a century earlier. Each had to deal with a powerful foreign threat (North Korea and Communist China); each succeeded a Japanese colonial regime that it was eager to forget; and each had a close alliance with the United States that provided a broad perspective on capitalism. Capitalist development transforms societies, dissolving hierarchies and undermining tradition. No one has more to lose from this process than those who already possess wealth and power, and because they control the government, they are usually in a position to block change. At the very least, capitalist development reshapes property

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rights and rewrites contract and labor law, all of which requires the support of political authorities. In early modern Europe, governments encouraged the first stirrings of capitalist development because they thought it would give them advantages over foreign rivals. In Japan, South Korea, and Taiwan, new regimes embraced it to strengthen themselves against foreign threats. In most cases, however, the political calculus is different.

1 4   C A P I TA L I S M A N D P R O G R E S S

Capitalism has never lacked for critics who find the helterskelter of markets hopelessly chaotic and contend that by giving economic profit priority, the system debases human relationships, reducing everything to the cash nexus. The first objection reflects a profound misunderstanding of capitalism. The average supermarket has roughly twenty thousand categories of goods, and major theme parks host about fifty thousand guests a day. Large enterprises manage supply and distribution chains that stretch across oceans and continents, and even small businesses often have dozens of employees serving hundreds of customers a day. Casual observers might find this activity chaotic, but they will also find stores fully stocked and telephones connected. No individual or institution coordinates this activity, and no doubt the lack of central direction explains why many equate capitalism with anarchy. Instead, markets perform the task, providing individuals and enterprises

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with constant feedback that guides decisions. The result is decentralized but orderly. The oft-repeated criticism that capitalism reduces everything to monetary terms—the cash nexus—reflects an equally profound misunderstanding. Capitalism is an economic system, and profit is certainly the best, and arguably the only, measure of economic success. Assuming competent accounting, due regard for externalities, and relatively efficient markets, profit represents the surplus, the value of output above the cost of production, and it finances art, philosophy, religion, politics, and even in a sense leisure. Criticizing capitalism because it focuses on profit is like criticizing a horse because it runs rather than flies. Capitalism, however, constitutes but one facet of capitalist society. Traditional societies are of a piece, like apples, but capitalist ones are more like oranges, consisting of wedges, linked but distinct. Other fields such as religion and the arts fall under the rubric of civil society, the dense network of religious denominations, fraternal organizations, reform clubs, charitable foundations, and more. Capitalist development creates space for civil society by undermining hierarchies and elevating the individual, although the latter has its own dynamic. In capitalist societies, much of the population “works to live,” drawing meaning and purpose from family, religion, charitable work, or fellowship rather than from their jobs. The nonprofit sector—schools, hospitals, churches, museums, foundations—is a major employer, and the leaders of these

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organizations, who are clergy, doctors, and academics, enjoy substantial prestige and influence, though they are neither capitalists nor in most cases particularly wealthy. Whereas capitalism offers material progress, civil society offers moral progress. The cash nexus is not all-encompassing. Like civil society, government in capitalist societies is autonomous, connected with and affected by the economic system but far more than an extension of it. Because society is in constant flux, the state cannot embody it. Rather, government is a forum in which various interests fight battles, arrange compromises, and launch common projects. Capitalist development requires a legal framework that defines and defends markets and private property, a stable financial system, corporate charters, and bankruptcy laws. Without these, the system cannot function. Yet just because capitalists have influence with and enjoy benefits from government does not mean that they monopolize political power. Governments also deal with externalities like pollution created by private enterprise, and most devise programs such as Social Security to protect citizens from the uncertainties of economic life inherent in capitalism. Many aspects of political activity, such as foreign policy and education policy, have no obvious “capitalist” dimension at all, though specific entrepreneurs and enterprises may have a stake in them. Capitalist societies offer both material and moral progress. Capitalism itself provides an ever-rising standard of ­living driven by a constant stream of new products like electric lights, automobiles, and smartphones. Moral progress

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is harder to define—does the liberalization of abortion laws represent progress or retreat? Nevertheless, both civil society and government seek to improve society, and in some cases, such as the abolition of slavery, progress is undeniable. Capitalism’s radical critics offer their own version of progress. Communists and fascists seek to organize society around the concepts of class struggle and nationalism, respectively. Social democrats and progressives seek to base economic decisions on standards of fairness and equality. All imagine that their changes will elevate humanity to a higher plane; all plan to use the state to reshape society; and all have a strong egalitarian bent, though each defines “equality” quite differently. These alternatives differ greatly. The progressive New Deal, launched by Franklin D. Roosevelt in the United States in the 1930s, was in no way analogous to Joseph Stalin’s programs of agricultural collectivization and crash industrialization, on which the Soviet Union embarked at about the same time. Nevertheless, all follow the same sequence. First comes the idea, then government action, and finally society settles into a new, ideally better, form. Capitalist development follows a very different order. It begins with the efforts of entrepreneurs who do not think too much about the larger implications of their actions. Next, civil society and government adjust to the changes unleashed by entrepreneurs. Finally, thinkers like Adam Smith and Joseph Schumpeter describe what has happened and try to make sense of it. Action is the parent of the idea, not the other way around.

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Unifying ideologies such as those offered by capitalism’s critics represent a return to tradition, reorienting society around a central principle. Their supporters are often revolutionaries but only because society does not fit their model. If they gain power and implement their program, they can become very conservative. Between the mid-1960s and the mid-1980s, the leaders of the Soviet Union showed no interest in meaningful social, political, artistic, or economic innovations—after all, their system represented the culmination of history. Unfortunately for them, the country was locked in the Cold War with the United States, a dynamic capitalist society, and the struggle overtaxed Soviet resources. Social democrats and progressives rarely slip into such reaction, in part because they eschew the political repression that is central to communism and fascism. They cannot pretend that they are the ultimate product of human experience. Nevertheless, their ideas of fairness and equality often translate into protecting existing interests from change, be it local merchants challenged by chain stores, unionized workers in declining industries, or cab companies threatened by ride-sharing services like Lyft and Uber. Capitalist development, by contrast, represents something new. There is no overarching principle or ideal but simply a framework of markets and property rights in which individuals pursue their own interests on the assumption that in so doing, they serve the common good. Profit is the metric, and innovations that deliver it earn wealth and prestige even if they also disturb or even

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destroy established interests. Financial markets allocate capital according to anticipated earnings, providing in the going rate of interest a definition of success and punishing enterprises that fall short. By offering large rewards for human initiative and ingenuity, and imposing few restrictions on them, capitalism creates wealth on an unmatched scale. At the same time, by constantly reorganizing economic life, it forces social life into new channels. Traditional patterns and practices become obsolete as people move in search of new opportunities and as successful innovation creates new centers of wealth and power. No longer do individuals receive an identity from the world around them. Instead, they must define themselves through the varied institutions of civil society. The only constant is flux—the permanent revolution.