November 9, 1989, the day the Berlin Wall fell, marked the end of the Cold War struggle between communism and capitalism. Capitalism had triumphed, and communism was reduced to a mere historical curiosity. Looked at that way, the term “capitalism” seemed to refer to a uniform type of economic organization, something we could all recognize when we saw it, even if we had no formal definition at the ready.But this view of capitalism turns out to be a seriously misleading oversimplification. Generally, an economy is capitalistic when most or at least a substantial proportion of its means of production—its farms, factories and complex machinery—are in private hands rather than being owned and operated by the government. But that definition admits a wide range of variation, as we explain below in describing four main groupings of capitalist economies. More important, variation in capitalist systems matters. The form capitalism takes in a country has implications not only for its growth performance, but also for its attitudes toward human and political rights, global trade and investment, the international system and, in particular, the United States. That is why it is at least as important for U.S. foreign policy to encourage entrepreneurial forms of capitalism abroad as it is to encourage democracy. It may be even more important. A more nuanced view of capitalism distinguishes between four types: oligarchic capitalism, in which the bulk of power and wealth is held by a small group of individuals and families; state-guided capitalism, in which government guides the market, most often by supporting particular industries that it expects to become “winners”; big-firm capitalism, in which the most significant economic activities are carried out by established large enterprises; and entrepreneurial capitalism, in which a significant role is played by new, innovative firms. About the only thing these four types of capitalist systems have in common is that they recognize the right of private ownership of property. Otherwise, economies in any one category will tend to have different growth records and very different attitudes toward the rest of the world than economies in the other categories. Of special significance for development, while state-guided capitalism may be successful for a time, over the long haul, as economies approach the global technological frontier, they must embody some combination of entrepreneurial and big-firm capitalism to continue their growth or otherwise face stagnation and decline. We want to be clear: No single type of capitalism is permanently dominant within and across economies and over time. Economies are usually different mixes of the various types at different stages in their histories. In addition, there are “pre-capitalist” economies, home to hundreds of millions of people, which do not fit any of the four archetypes we describe here.1
A pre-capitalist economy is typically poor (with annual per-capita income below $1,000), and with few of the institutions associated with capitalism, particularly state-protected property rights. In many pre-capitalist economies governments are weak; clans or tribes largely set the rules. Nevertheless, distinguishing these four basic archetypes is the necessary first step to more sophisticated analysis. Oligarchic Capitalism
Oligarchic capitalism easily can be confused with state-guided capitalism. Under both, the state is apt to be heavily involved in directing the economy. However, capitalism is oligarchic when government policies are designed predominantly or even exclusively to promote the interests of a very narrow (and usually very wealthy) portion of the population or, worse, the interests of the ruling autocrat’s own friends and family. This common form of capitalism, which encompasses perhaps a billion or more of the global population, is prevalent in much of Latin America, in many states of the former Soviet Union, in most of the Arab Middle East and in much of Africa. It is not too much to say that, outside of North Korea and Cuba (the only two genuinely communist countries remaining), all of America’s serious foreign policy problems arise in countries where oligarchic capitalism is dominant.The central objective of economic policy in oligarchic capitalist systems is not growth but the maintenance and enhancement of the economic position of the few (including government leaders themselves) who own most of the country’s resources. To the extent that ruling elites are interested in promoting growth, it is only a peripheral objective designed to deflect popular energies away from popular protest and rebellion. It is precisely here that the tragedy of foreign aid business-as-usual is located. Development assistance to oligarchies fails to generate growth not because there is anything necessarily wrong with the economic models and advice of Western consultants. Aid fails because local oligarchs don’t want to grow their economies. Instead, they employ foreign largesse to further cement their hold on power by using it to pay off their cronies. For that reason, insofar as aid money has made it easier for autocrats to stay longer in power, aid has been counterproductive to economic development in countries afflicted by this particular, largely dysfunctional form of capitalism. All oligarchic capitalistic economies share several features, the most significant being sharp inequality and “informality.” As to the former, oligarchic capitalism fosters extremely skewed income distribution and net wealth patterns. The so-called Gini coefficients, a standard measure of inequality, are near 50 to 60 (suggesting a high degree of income inequality) in Latin America, a region with many oligarchic capitalist countries. (In contrast, the Ginis in the OECD fall in the 25–40 range.) Several Latin American countries attempted to enhance growth in the 1980s and beyond by shedding the import-discouragement strategy pushed by Argentine economist Raoul Prebisch in the 1950s. The Prebisch strategy sought ostensibly to protect local “infant industries” from foreign competition until they could compete in global markets. But powerful and wealthy local families typically owned those “infant” industries, underscoring the consistency of import protection with the oligarchic capitalism we have described. The abandonment of that approach by some Latin American countries and the hesitant steps toward the opening of their economies to foreign competition over the past two decades suggests some weakening of the oligarchic-capitalist model. Not coincidentally, extreme inequality of income distribution and net wealth is inimical to growth. In 2006, the World Bank devoted its entire World Development Report to the relationship between inequality and economic development, making a compelling case that wealth inequality impedes economic growth in at least two ways. First, those with power and wealth tend to distort the cost of capital across social groups, thus leading to wasteful and inefficient allocation of resources while impeding opportunities for those who are penalized. Narrow, powerful elites also tend to put in place and maintain institutions and rules that benefit only themselves at the expense of wider publics. These tendencies are hallmarks of economies where oligarchic capitalism dominates, and quite naturally drives a good deal of economic activity outside of formal institutions—to the informal economy. Peruvian economist Hernando de Soto has popularized the concept of the informal economy over the past two decades. De Soto uses the term to describe a process wherein individuals and firms engage in inherently constructive economic activities—building homes, selling goods and services and so on—that are nevertheless technically illegal. When getting official licenses (or, in the case of land, titles) has been made impossible, people often go ahead without them. This definition of informality distinguishes it from criminality, which is extra-legal activity that undercuts the fabric of society (for example, kidnapping, drugs and money laundering). Informality is widespread in oligarchic capitalist systems. Ruling families have no interest in extending formal rights throughout the population. They fear the competition that new entrants into the formal economy can bring, so governments backed by oligarchic elites go out of their way to impede informal firms and individuals from operating openly and legally. De Soto first studied informality in Latin American in the 1980s. He has since documented its prevalence in much of Africa and parts of Asia. Even Russian President Vladimir Putin acknowledged the difficulties of establishing new businesses in Russia, lamenting on state-run television in March 2005 that, “The government and the regional authorities have failed to create conditions for small-and-medium-sized businesses to flourish. Everyone who opens a new business and registers a company should be given a medal for personal [bravery].” From Russia to Saudi Arabia to Mexico, oligarchic economies breed international troubles. The frustrations of those who are not among the elite are producing mass emigration, recruiting grounds for terrorist and international criminal organizations, and a tendency among regimes to encourage the fear of outsiders as a means of bolstering their own wasting legitimacy. Apart from non-state actors, oligarchic polities as a class generate the greatest foreign policy challenges to the United States. State-Guided Capitalism
As the label suggests, state-guided capitalism exists where governments, not private investors, decide which industries and even which individual firms should grow. Government economic policy helps chosen “winners.” The overall economic system nonetheless remains capitalist because, with some exceptions, the state recognizes and enforces property and contract rights, markets set the prices of goods, services and wages, and at least some small-scale activities remain in private hands. From the Pacific Rim and China to France, countries that rely mainly on state-guided capitalism present a different set of foreign policy challenges to the United States—mainly over trade and economic policy.Governments of state-guided capitalist systems employ many tools for guiding growth, but the most important is the explicit or implicit ownership of banks. Only in the United States is the transmission of financial resources from savers to producers carried out primarily in organized capital markets rather than banks. In most countries, even those with stock exchanges, banks are the key source of growth capital. In developing economies, and even in some developed ones such as Germany, however, the government still owns a significant share of the banking system. In India, state ownership accounts for 75 percent of all bank assets. Four state-owned banks dominate the Chinese financial system—although, under its WTO accession agreement, China is scheduled to privatize all four by 2007. Even without direct ownership, governments in a state-guided capitalism system can still direct or strongly “persuade” banks to do their bidding. South Korea is a good example of the former, and Japanese “administrative guidance” is a good example of the latter. State-directed capitalist governments can and do guide their economies in other ways, as well. They often pick companies or sectors to favor with tax breaks, exclusive licenses (legalized monopolies), contracts and protective tariffs. Permission for foreign direct investment is commonly granted only on the condition that the foreign partner share and eventually transfer its technology and know-how to the government-favored local partner. China’s joint ventures with American manufacturers and Japanese arrangements with U.S. aerospace companies are examples of such arrangements. Countries that follow state-guided capitalism also tend to favor “national champions” whose success government policy is bent on ensuring. State-driven capitalism may seem little different at first blush from central planning, but this is not the case. In centrally planned economies, the state not only picks winners, it also owns the means of production, sets all prices and wages, often cares little about what consumers want, and thus provides essentially no incentive for innovation. The bureaucrats who ran the large “firms” in former Soviet-bloc countries, which were the apotheosis of central planning, were paid according to the amounts their plants produced, regardless of quality and without reference to whether consumers actually wanted the output. Central planning is by nature not conducive to the adoption of breakthrough technologies. Even the seemingly innovative Soviet space program of the early Cold War period was on closer examination merely the kind of thing state socialism does best: a massive command-and-control activity for a specific, limited purpose. Unlike the initiatives of state-guided capitalism, central planning generated no long-run economic benefits. State-guided capitalist economies, on the other hand, can be highly successful. To turn out products (and, increasingly, services such as “call centers”) that sell well in international markets, economies that lag behind the technological frontier need only gain access to advanced foreign technology and combine it with lower-cost labor. This is essentially what successful Asian economies have done, one after the other, for much of the past half century. Accessing foreign intellectual property is not hard. Foreign technology can be imported through foreign direct investment. Knowledge can be gained by sending nationals abroad to foreign universities. An even bolder strategy is to encourage, or at least not limit, the ability of domestic residents to emigrate to technological-leader countries like the United States, hoping that they succeed and then either return or facilitate from abroad the startup and growth of new home-grown enterprises. India is currently the leading practitioner of this “reverse brain drain” strategy. The approach may have looked like a gamble several decades ago, but seems to have paid off handsomely now that successful Indian entrepreneurs in the United States have either found their way back home or invested in new Indian enterprises. However it has been accomplished, countries that have adopted a strategy of “export-led growth”, largely facilitated by state guidance, have been successful only because their exports have had someplace to go. That somewhere has most often been the United States, or more recently, in the case of the Asian exporters, other countries in Asia where incomes are rising and governments have the foreign exchange earned through exports to pay for imported goods. But despite many successes, countries that adopted state-guided capitalism have learned that the system brings with it major dangers. Governments that successfully guide their economies often conclude that the good times will keep rolling if only they do everything just as they have been doing it. But the world changes. Old strategies go stale. And when, as happened in Japan during the 1990s and well into the current decade, the government fails to adapt, the economy cannot adapt either and falls into stagnation or decline. States can best guide their economies when mature industries in other countries serve as well-defined targets first for emulation and then for overtaking. But as the economies of such states catch up to the technological frontier, the low-hanging fruit will have been picked. At that point, or perhaps well before it, the drawbacks of state-guided capitalism become more evident: an inability to innovate, susceptibility to corruption and a reluctance to channel resources from low-yielding activities toward potentially more rewarding ventures. The overriding pitfall of state-guided capitalism is that governments make poor investors. They often pick losers to win and winners to lose, they overinvest and they hang on too long. Unfortunately, the problems of state-guided capitalism are America’s problems as well. It used to be said that when America sneezes, the rest of the world catches a cold. In the increasingly interconnected global economy, the reverse seems to have come true. The Asian financial crisis of 1997–98, which had some of its seeds in the risks of state-guidance, nearly caused a global economic crisis. Japan’s decade long slowdown, and its desire to export its way out of its problems, has continued to cause trade frictions. China’s state guidance has become a leading source of that country’s trade difficulties with the United States. America clearly has an interest in seeing other countries graduate from state guidance into more entrepreneurial forms of capitalist economics. Big-Firm Capitalism
Big-firm capitalism is characteristic of economic systems dominated by large companies whose original founders have either passed from the scene or are no longer in effective control. Ownership is usually dispersed among many shareholders, often including some large “institutional” investors such as insurance companies, pension funds, universities and foundations. Professional managers are the agents of these principals, giving rise to the well-known “principal-agent” problem—that of ensuring that managers actually act in the best interests of the owners of the firms they manage.All major industrial countries have elements of big-firm capitalism. Some, like Germany and France, combine it with significant elements of state-guided capitalism. Others, like the United Kingdom, mix it with larger doses of entrepreneurial capitalism. In general, the more big-firm capitalist countries lean toward entrepreneurial capitalism, the better they seem to work as global policy partners with the United States. Two Japanese giants, Honda and Toyota, exemplify the best of big-firm capitalism. These are firms that not only have continuously improved their automobiles, but have been radical innovators as well (most recently in the case of hybrid cars). A few large Korean manufacturers—Hyundai and Samsung—have also displayed innovative zeal in recent years. And several European economies are also host to a number of successful and innovative large firms that are strong in the automobile, capital-goods and consumer-appliance industries, among others. The United States, too, has its share of “big firm” success stories, a prime example being General Electric, which, during CEO Jack Welch’s tenure, was run more as a collection of individual entrepreneurial enterprises than as one large company. Indeed, large firms are essential to the functioning of any economy, if for no other reason than because the founders of vibrant, new companies—the entrepreneurs—eventually must pass the reins of power to non-founding managers. At this point, firms confront a fork in the road: Down one path lies successful expansion and ideally other rounds of innovation, while down the other lies stagnation and possible demise. If the initial firm was a radical innovator, it is unlikely that it will repeat that success in its second and third generations of management. Larger, second-generation companies typically have flatter, more lock-step compensation systems that cannot easily reward individuals or groups within the firm for breakthrough inventions to the same degree that the market rewards lone inventors or entrepreneurs. In addition, breakthrough technologies can quickly make existing products and services obsolete, and for that reason they may be fiercely resisted within large organizations. These factors help explain why only a small fraction of the R&D; budgets of large firms is devoted to basic research; why research and patents filed by small firms are at least twice as likely to be “high impact” patents as those filed by bigger firms; why large U.S. firms like Procter & Gamble, Intel and the large pharmaceutical companies increasingly seem to be “outsourcing” much of their R&D; to smaller firms that come up with new products and then sell themselves to those larger companies (some of which may make equity investments in them in the first place). This is also why Sony of Japan—which originated the transistor radio, the Walkman and the Trinitron television, and was once one of the most successful innovative large firms—seems to have lost its way. Big firms nonetheless can grow and prosper by refining existing products and services, and occasionally developing new ones. This they typically do after considerable market research about what consumers will and won’t buy. The innovation process becomes routine and predictable, picking up “three yards at a time” (to use an American football analogy), rather than seeking the breakaway touchdown. Such constant, albeit routine, refinement of products and services is necessary in any economy. Large firms are also essential to mass-produce innovations that radical entrepreneurs are unable by themselves to manufacture in a cost-effective way. Examples are legion, from Ford with the mass production of the automobile, which had seen a long line of inventors before, to today’s large pharmaceutical companies, which have the resources to conduct the expensive and time-consuming clinical trials on breakthrough therapies invented in universities and small companies. The Achilles’ heel of big-firm capitalism, however, lies in its tendency toward sclerosis. It is no accident that in the leading exemplars of big-firm capitalism, continental Europe and Japan, labor markets are rigid, employment security is taken for granted and firing is rare. The irony, of course, is that in their quest for security, these big-firm economies are failing to provide it. After outperforming the United States with lower unemployment rates through the 1950s, 1960s and 1970s—a fact many people seem to have forgotten—European economies over the last decades have suffered structural unemployment rates that substantially exceed those in America. Both Europe and Japan now find themselves aching to create an entrepreneurial culture to help generate the new jobs that their existing big firms cannot. In short, big-firm capitalism at its best generates sufficiently large cash flows to finance internally the continuing, incremental improvements in products and services that are staples of any modern economy. At its worst, big-firm capitalist enterprises can be reluctant to innovate and resistant to change. That reluctance can lead to national policies that retard economic and technological change, as we have seen in EU trade policy in recent decades. So long as the United States remains the world’s most dynamic example of entrepreneurial capitalism, it will have unsteady relations with more purely big-firm capitalist economies. We will argue over many things; everything, it seems, except what really separates and defines us economically. Entrepreneurial Capitalism
In entrepreneurial capitalism, large numbers of people and companies not only have a strong incentive to innovate, but also have the means available to commercialize radical or breakthrough innovations. These breakthroughs, in turn, raise productivity: directly when embodied in new products and services, and indirectly, by facilitating the development of complementary technologies and businesses. Faster productivity growth, in turn, means faster growth for the whole economy and improvements in living standards.Entrepreneurial innovations are bolder than the incremental innovations of big-firm capitalism. But taken together, original breakthroughs and subsequent incremental developments have improved living standards beyond anything our ancestors could have believed. Examples stretch from transportation and communications systems to nutrition and health-care revolutions. By definition, entrepreneurial capitalism, and the transforming technologies it creates, would not exist without entrepreneurs. Radical breakthroughs tend to be disproportionately developed and brought to market by a single individual or new firm. These individuals and firms have often (although not necessarily) been inventors, but they have also been able to recognize an opportunity to sell some thing or service that hadn’t been there before, and then act on it. Smaller, younger firms produce substantially more innovations per employee than larger, more established ones. Indeed, with rare exceptions, truly innovative entrepreneurs can only be found in capitalist economies, where the risk of spending time and money can be handsomely rewarded and the rewards safely kept. Entrepreneurial economies are open to brainstorming and experimentation, which pay off because the people at large, with their diverse mix of skills and different kinds of knowledge, are more likely to devise and implement good ideas than any group of planners or experts. It turns out, however, that large second-generation firms are essential to ensure that radical innovations take root. For example, Bell Laboratories, which was perhaps the most successful research arm of any major corporation (when it was owned by AT&T;), was responsible for two of the most important big-firm radical innovations in recent decades: the transistor and the semiconductor. Second-generation firms, in turn, often produce new entrepreneurs. Building upon these two innovations, others brought to market a series of new consumer and business goods, from transistor radios to pocket calculators and, eventually, personal computers, which entrepreneurs like Steve Jobs, the founder of Apple, developed in the 1970s at a time when existing firms did not yet see their value.
Innovation did not stop there. The PC industry, in turn, gave a huge boost to the fledgling software industry, also launched by cadres of independent entrepreneurs. The legendary growth of Microsoft under Bill Gates into one of the world’s largest and most profitable companies thereafter provided a market for other computer application software.The record is therefore clear: The most successful capitalism is the one that thrives from the working synergy between entrepreneurial and big-firm capitalism and that minimizes oligarchic and state-run attributes of less effective capitalist systems. State-run capitalism may be wise for some societies that use the broad popular desire for economic growth to build effective state institutions, including most critically the establishment of the rule of law. But once those institutions exist, the state is wiser still to remove itself from the economy. Think of it as the institutional or governance expression of the “infant industries” argument. The Policy Challenge
Clearly, other countries have witnessed the success of the synergy between entrepreneurial and big-firm capitalism, and they are learning from it. Ireland, Israel and the United Kingdom all have shed or are in the process of shedding the guiding role of the state in their economies and are placing their bets on entrepreneurs. India, a long-time practitioner of “state-guided capitalism”, has embraced entrepreneurship, more by accident than by design, in a small but growing corner of its economy: call centers and software design. China, formerly the world’s largest centrally planned economy, has developed a new form of semi-state-guided entrepreneurship that has helped make its economy the world’s fastest growing of the last decade.That major countries are moving toward entrepreneurial capitalism is good for America’s foreign policy and for international security as a whole. The more any economy reflects entrepreneurial capitalism, the more innovative and prosperous it will be. Furthermore, as such economies become better integrated into the high end of the global economy, the more likely they will be to contribute to the long-term peace and stability of the world. The challenge for Americans in the years ahead will be to live with the growing success that other countries will enjoy as they embrace entrepreneurial capitalism. In particular, Americans must learn to live with the fact that we no longer have a monopoly on our once unique blend of entrepreneurial and big-firm capitalism. This is a good thing if it spurs the United States to maintain its commitment to both innovation and incremental improvement. It will be unfortunate, however, if the fear of stiffer competition induces American policymakers to adopt a more defensive form of capitalism that, over time, retards the remarkable growth in innovation that has so far characterized the U.S. economy. Successful entrepreneurial economies embrace and generally encourage change. They do not erect barriers that prevent money and people from moving from slow-moving or dying sectors to dynamic ones. They do not wall off their existing producers from more efficient ones in foreign countries. They recognize the importance of education and human capital generally, and they seek out better ideas wherever they can find them, even abroad. We have much to learn about openness to foreign ideas and direct investment from China, the Asian Tigers and India—the economies that many Americans and their political leaders now seem to fear most. We also have much to learn from our own past about the rewards of staying open to the world and the penalties of trying to close it out. Most of all, as we look to the future, we have an enormous stake—both for our national security and our international economic policy—in doing all we can to further the movement of countries toward entrepreneurial capitalism. This is not a matter of making them more like us, but of making everyone “all that we can be.”
A pre-capitalist economy is typically poor (with annual per-capita income below $1,000), and with few of the institutions associated with capitalism, particularly state-protected property rights. In many pre-capitalist economies governments are weak; clans or tribes largely set the rules.