I often lean on the right politically. The idea that the free market will work is compelling. Free markets may be good at generating some form of wealth, but as we saw on the stock market, this wealth may turn out to be artificial. We have another example of the rule: pure theory is wasteful.

But why does capitalism appear to work so well, so often? As an amateur economist, I have been reading The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism by William J. Baumol.

The Roman Empire was not characterized by capitalism: commerce and industry were not encouraged. Yet, the book begins with a sobering thought: eighteen century England had just caught up the the per-capita wealth under the Roman Empire. In fact, we learn in this book that the Roman Empire had a working steam engine in Alexandria! (To be fair, it should probably not be regarded as a steam engine. It was more of a curiosity.) The Romans had also the water mill in their textbooks, but it was rarely used. The author also review Imperial China which was also filled with innovations, but few of them were ever used for profit.

Baumol argues that innovation is the only way to explain the eightfold increase in per-capita wealth observed in the XXth century. But, he points out that capitalism is probably not optimal at generating innovation:

  • Innovators are rarely rewarded in proportion with the value of their discoveries. In fact, quite often, inventors have to fight hard to be rewarded at all. Hence, not as much effort as could be is invested toward innovation.
  • Innovation can perturb highly profitable markets. Hence, capitalists may actively block some innovations.
  • Capitalism does not necessarily encourage the spread of innovation: it can be profitable to prevent others from using new ideas.
  • Capitalism offers easier ways to earn money than innovation: legal and market-based monopolies are much more profitable.
  • Capitalism often result in a winner-takes-all scenario where collaboration and diversity are irrelevant.

Instead, capitalism is superior at putting innovation to good use. The Romans had a steam engine, but nobody had any interest in putting it in practice. With capitalism, some people can make a profit out of such innovations. The profit may be small and the enterprise might be risky, but at least, there is a route. In Imperial China or in the Roman Empire, you could come up with great ideas, but nobody would listen and you had no chance to put it in practice.

The free market is simply not such a great idea in itself. It does not explain the great wealth that was created in the last two hundred years. Instead, the ability of innovators to put their ideas into practice is the key to our future wealth. The stock exchange is not a requirement.

Being able to move your factory to China where the workers are cheaper is not essential. In fact, if you were forced to keep your factories in Montreal where wages are higher, you might very well need to rely more on innovation.

The free market is not letting us down. It was never meant to save us.

1 Comment

  1. The free market is letting us down relative to its own marketing of its benefits. It’s only after it screws up that free market fanatics say “we never promised you a rose garden, chump”.

    Solution: Treat the marketing like the self-justifying bullshit it is. Be relentlessly alert and skeptical.

    Comment by CW — 3/1/2009 @ 20:34

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