Can American Capitalism Survive?

Richard M. Reinsch, II

Spring 2020

American capitalism is once more under attack, this time from opponents seeking democratic socialism on the left and economic nationalism on the right. Each side seeks to impose industrial policies aimed at reviving jobs and increasing wages in the manufacturing sector. Support for free markets is thus increasingly an embattled stance within policy circles, a condition not seen since the end of the Second World War. Particularly striking is the loss of consensus regarding dynamism and free markets on the right, where support for capitalism used to be almost definitional.

Proposals for alternatives from many Democratic leaders are generally more extreme than those from the right, and would be more damaging. Calls to discharge student-loan debt, raise the federal minimum wage to $15 an hour, and increase income-tax rates for most Americans — all while doubling capital-gains taxes and imposing a "wealth tax" — would be economically devastating if they ever came to fruition. Implementing the Green New Deal's stated objective of simultaneously eliminating greenhouse-gas emissions and solving economic inequality would result in cultural, political, and economic conditions best described as despotic. Such policies, which have drawn wide support from Democratic presidential candidates this year and from the broader party, would obviously be installed incrementally, forestalling a total capital strike. But they nevertheless entail a striking rejection of free-market capitalism, and represent a remarkable detachment from reality among many leading minds of the American left.

On the right, economic nationalists propose a seemingly more sensible strategy of managing capitalism so that its gains are broadly directed toward workers, especially those with lower levels of education and training. Oren Cass recently headlined this journal with an essay titled "Putting Dynamism in Its Place," which questions whether, for average Americans, the benefits of capitalist vibrancy are worth the disruptive costs of our free-market system. Cass argues that jobs have been destroyed but not created at a comparable rate, and the jobs that have been created are often not located in areas that are geographically or culturally suitable for many American workers.

Moreover, Cass argues, free trade is no longer working for Americans because we no longer have balanced trade, as evidenced by our longstanding trade deficits. Although we send our dollars to foreign exporters for their goods and services, and they send our dollars back to us for our goods and services, Cass asserts that this is not balanced, since they also use their newly acquired money to purchase federal debt and equity securities. To Cass, this means we lack parity in our imports and exports. We're therefore left with the downsides of trade, such as allowing foreign goods to replace American goods, without enjoying trade's full benefits, including the job creation tied to increased purchases of American-made goods.

Cass and other economic nationalists are wrong on both the facts and aims of free trade. Both democratic socialists and economic nationalists have failed to grasp the fundamental insights of Joseph Schumpeter, one of the 20th century's most profound thinkers on the nature of economic processes: The point of free trade is to gain access to a greater variety of goods and services; we work, ultimately, to consume. Schumpeter also cautioned policymakers to look at the bigger picture, insisting that economic problems, or really any economic circumstances, could be better assessed with the passage of time. Criticisms of the trade deficit fail this Schumpeterian test of time: We've had trade deficits for over four decades, yet job creation has remained robust across most of the economy. Cass's balanced-trade critique fails, too, since deficits have not reduced the total number of jobs in America.

Cass resolutely focuses only on the deficit itself, falling prey to the formalism of a definition rather than confronting economic facts. Market creativity and cross-sector dynamism play no role in his analysis, which focuses solely on the manufacturing sector and manufacturing employment. Cass and other economic nationalists have resurrected the term "industrial policy," urging federal-government intervention in the manufacturing sector to achieve what Cass calls balanced job and wage growth, and growth in the wider economy through manufacturing innovation.

Economic nationalists insist that their policies would restore manufacturing jobs and that this would be a good in itself. They further insist that a host of other problems, ranging from the opioid crisis to men without work (to use Nicholas Eberstadt's term), will not be resolved without the return of manufacturing jobs. But certain facts remain: Excellent jobs abound in this economy, many more than existed during the height of manufacturing employment. The majority of evidence indicates that a nationalist policy will only make us poorer on the whole, while increasing the size of government. And slogans suggesting that the return of manufacturing jobs will resolve deeply rooted societal issues actually obscure the real problems Americans face.

THE SCHUMPETER ECONOMY

Economist Joseph Schumpeter understood this more clearly than anyone, and looked to the American economy as the savior of capitalism. Born in Austria in 1883, he moved dozens of times across countries and continents, and so was an outsider wherever he settled. As Thomas McCraw observed in his biography of Schumpeter, Prophet of Innovation, Schumpeter's economic judgments had a validity and independence informed by his familiarity with varied cultural and political contexts. He engaged with his discipline almost as an outsider, relying not only on mathematics and theory, but also on labor and employment history, which he thought were central to understanding capitalism. According to Schumpeter, history and the unfolding of time are crucial given the jolts and starts of markets. As he wrote, "Since we are dealing with a process whose every element takes considerable time in revealing its true features and ultimate effects, there is no point in appraising the performance of that process ex visu [from its appearance] of a given point of time; we must judge its performance over time, as it unfolds through decades or centuries."

Given our current political conditions, invoking Schumpeter's term "creative destruction" strikes some as insensitive, especially those who have watched their neighborhoods, towns, and cities change for the worse at least in part because of trade. They understandably feel that if capitalist efficiency and innovation requires a certain amount of organizational and labor displacement, then surely corrective policy action is called for. It's a pity that Schumpeter's oxymoronic term is reflexively uttered by so many, while his rich and descriptive understanding of markets is so rarely understood. Conservatives, classical liberals, and libertarians of all stripes are typically raised on Smith, Mises, Hayek, and Friedman — and for good reason — but it was Schumpeter who saw capitalism more fully, in both its positive and disturbing dimensions.

He knew what many today have forgotten: We can't enjoy the life-altering improvements capitalism offers in technology, agriculture, manufacturing, transportation, housing, medicine, communications, and overall consumer experience without the destruction of previous modes of economic existence and organization. Schumpeter famously observed that capitalism turned on the function of the entrepreneur, whose quest for monopoly profits and status led to the upending of existing forms of commerce. Schumpeter justified the good of profits along these lines, in contrast to classical economic theory's models of perfect competition whereby profit shouldn't really exist. The desire for and attainment of profit creates opportunities for real gains in the economy, which make our lives better. To Schumpeter, there was no limit to the disruptions the entrepreneur could introduce.

His best-known book, Capitalism, Socialism and Democracy, was published in 1942, during a time when capitalism was being widely criticized on moral grounds. Schumpeter was skeptical that capitalism would survive, and suggested that if it did, it would be of a mixed variety, most likely oriented toward "laborism." For Schumpeter, the nature of capitalism lay in its evolutionary process of development, punctuated by intense periods of leapfrogging technological progress and innovations. He counseled patience in judging capitalism, which in practice amounted to telling the intellectual class to think deeply before it condemned an economic phenomenon it did not really understand. The key was time and the perspective it provided.

And if time was key to making accurate judgments about the progress of capitalism, then those making snap judgments about declining investment opportunities, workers' shares of profits, unemployment, and anti-competitive monopolistic conditions were surely wrong about the real growth that was being achieved. New Deal types who engaged in this kind of critique were rebuked by Schumpeter's challenging findings.

This broad, evaluative capacity of Schumpeter's writings remains crucial to accepting the surprising and at times dismaying results of free enterprise. On this point, Schumpeter was never optimistic that a wide swath of opinion would approve of capitalism, because its short-term consequences were so painful for certain groups. While people who found themselves in the favorable conditions created by capitalism would be unlikely to give credit to the market, at the first sign of trouble, they would probably turn on owners and employers. Defending capitalism would always be a difficult task.

THE COSTS AND BENEFITS OF TRADE

Schumpeter pointed to the United States as an example of unparalleled growth whose existence alone might vindicate capitalism as a superior system. Indeed, previous wealth creation in America actually made the social and welfare legislation of the New Deal period possible in the first place. The surplus gains generated by capitalism in America ensured that taxation for such purposes could be done without undue economic interference. As he argued, "without innovations, no entrepreneurs; without entrepreneurial achievement, no capitalist returns and no capitalist propulsion."

Using the reasoning and perspective advocated by Schumpeter, we might wonder why many are so focused on manufacturing jobs, which currently constitute only 8% of employment. Some argue that concerns over these job losses are due to a manufacturing wage premium, but the evidence that such a premium exists is not nearly as clear-cut as industrial-policy advocates suggest. According to the Bureau of Labor Statistics, in December 2019 the average hourly wage for production and non-supervisory workers in manufacturing was $22.46; for production and non-supervisory workers in the private-sector service industry, the hourly wage was $23.53. Construction workers have a higher wage than manufacturing workers, as do those in mining and extraction industries.

Let us assume for a moment, however, that there is a manufacturing wage premium. Even if average manufacturing wages were higher than, say, service-sector wages, it does not follow that tariffs or other interventions would create manufacturing jobs that pay as much as the current average. The likely reason for the comparatively low number of manufacturing jobs in the U.S. is that additional manufacturing activity using human labor would be an inefficient use of resources and labor. Further, the wages for manufacturing jobs in the U.S. are as high as they are because these jobs depend on relatively high-skilled American workers. Not all manufacturing jobs are equal, and simply adding more manufacturing jobs in America would not necessarily mean we would need more high-skilled, high-wage workers.

Consider some of the effects of President Donald Trump's tariffs. Contrary to what many seem to believe, it is a disastrous time to impose tariffs — far worse than during the 1980s, when President Ronald Reagan instituted intermittent tariff policies, or when the Smoot-Hawley Act was passed in the 1930s, or when the Force Bill was enacted in the 1830s. This is because many goods we associate with American companies are made using foreign components. Meanwhile, about 56% of what we pay for something "made in China" goes to U.S. workers and companies, according to a recent analysis by the Federal Reserve Bank of San Francisco. While these products are generally assembled in Chinese factories, their component parts often come from the U.S.

This means, for example, that while the steel tariffs Trump enacted may benefit the 140,000 Americans in that industry, the 2 million Americans who work directly with steel as an input are less well off. The price of production has been raised, and those higher prices must be passed on to consumers. Nationwide, we're poorer as a result. The New York Federal Reserve recently found that Trump's tariffs cost consumers nearly $1.4 billion every month.

A wider, more diversified market of goods and services for consumers is one of the chief benefits of free trade, and working-class Americans are among the greatest beneficiaries. This is due to the large proportion of their income that is spent on clothing, food, transportation, and other basic goods — goods whose prices have been lowered thanks to free exchange. A 2018 paper by Xavier Jaravel of the London School of Economics and Erick Sager of the Bureau of Labor Statistics found that, between 2000 and 2007, free trade generated $202 billion in consumer benefits via lower prices — equal to $101,250 per manufacturing job lost.

It is also important to note that the decline of manufacturing employment began in the 1950s and has been steady since 1961, at four-tenths of 1% annually, regardless of other factors in the business cycle. This is not an exclusively American phenomenon; virtually every Western country has seen a decline in manufacturing employment.

Another point to consider is that, in real terms, growth in manufacturing has kept up with the growth in the economy over the past 70 years. According to data from the St. Louis Federal Reserve, the manufacturing share of nominal GDP declined from 28% in 1953 to 12% in 2015, but manufacturing's share of real GDP has been fairly constant since the 1940s, hovering between 11% and 13%. In 2015, for example, it was 11.7%. Manufacturing's roughly constant share of real GDP and total declining employment indicate an increase in productivity within the manufacturing sector relative to the overall economy, likely due to automation. In 1980, it took 10 man-hours to make one ton of steel; by 2015 that had been reduced to two hours. Economists Michael Hicks and Srikant Devaraj calculate that between 2000 and 2010, 13% of manufacturing job losses in the U.S. were trade-related; just under 88% were lost due to technological change.

This is not meant to minimize the decrease in American manufacturing jobs, which fell from about 19 million in 1979 to 12 million in 2016. That is a significant loss in employment. But it does not follow that these losses were driven primarily by free trade. It also doesn't mean that there were no compensatory trends in the last few decades, such as the creation of new work. During that same period, employment in the country's civilian sector grew from 99 million to 151 million jobs. Why should these workers return to manufacturing jobs?

In short, the manufacturing sector in America is still robust and highly productive. It has also experienced major technological gains. Current manufacturing-employment trends reflect these facts and affirm Schumpeter's predictions regarding the evolutionary nature of capitalism, with its tendency toward periodic leapfrogging. Despite the healthy state of the manufacturing sector, though, policymakers across the political spectrum loudly urge us to come to its aid.

INDUSTRIAL POLICY REVIEWED

One main motivation behind these calls for intrusive industrial policies seems to be the "China shock" — the term coined by economists David Autor, David Dorn, and Gordon Hanson to describe a 13-year period stretching from 1999 to 2011. In a 2013 paper, they assessed the effects of America's establishing "permanent normal trade relations" with China in 2000 and of China joining the World Trade Organization in 2001. They concluded that imports from China during that time resulted in a 21% decline in manufacturing employment, or a net loss of 2.4 million jobs, which translates to roughly 15,385 jobs each month. The jobs that disappeared were primarily in labor-intensive, low-skill manufacturing, which led many to conclude that American manufacturing had been "hollowed out." Today, the China shock is frequently blamed for a host of social maladies, including male unemployment, "deaths of despair," lower marriage rates, divorce, and opioid use.

This narrative is misleading. The decrease in male workforce participation began long before China entered the World Trade Organization in 2001; it seems to have coincided with the breakdown of family life in the early 1960s and the rise of President Lyndon Johnson's Great Society programs in the mid-1960s. And while the rate of what we call deaths of despair did increase after 1998, that increase occurred in spite of five years of rising wage growth for the bottom 20th percentile of male wage earners. Moreover, deaths of despair also rose in 2019 and affected a much broader group of Americans than white males without college degrees. Meanwhile, the economy has continued to grow, and wages for lower-income workers continue to rise. Male pay at the lower 20th percentile is 19% higher now than it was in 1993. In short, the China shock deserves less credit for our current problems than it currently receives; the real problem among thinkers on the left and right is a failure to understand how capitalism operates.

It is also important to put the job losses attributed to the China shock in perspective, as around 6 million jobs were also created during that time. Despite economic nationalists' reports of economic decline due to free trade, U.S. manufacturing output is 45% higher now than when NAFTA took effect in 1994, and has almost returned to its 2007 peak before the Great Recession began. American manufacturers produce 11% more now than they did when China joined the WTO nearly two decades ago. U.S. industrial capacity is also 66% greater now than when NAFTA was launched, and 15% higher than when China joined the WTO. The Industrial Production Index, which tracks the output of manufacturing, mining, electric, and gas utilities, marks today's output as a record high. U.S. exports today are 350% higher than they were when NAFTA commenced, 250% higher than when China joined the WTO, and almost 19 times what they were in 1975.

In the midst of this production and coordination of labor, skills, inputs, and outputs is an incredible amount of informational exchange that occurs mainly through prices and the signals these prices send to various players in the process. Consider Oren Cass's position that "market economies do not automatically allocate resources well across sectors" and that "vital sectors...suffer from underinvestment." From such assertions, he concludes that a "sensible industrial policy" could achieve better outcomes. Cass refrains, though, from telling us how we know that market economies fail to allocate resources well, or why some market sectors suffer from lack of investment. By contrast, consider Schumpeter's provocative description of what actually drives capitalism: "the new commodity, the new type of organization — competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives."

This failure to account for the realities of our economy — both its triumphs and its disappointments — suggests that industrial-policy advocates are unwilling or unable to accept the realities of capitalism. Capitalist economies are explosive by nature, and any attempt to tame them or direct them, or even to redistribute their benefits, fundamentally misses the motivations and functions of entrepreneurial actors within capitalism.

The approach advocated by Cass and others is not new, and it would prevent creative reconstruction by demanding that the existing margins of income remain the same. It would yield more stagnation, and could slow the economy to the point where America may lose its global edge, at least as far as innovation is concerned. At the very least, it is fair to question a policy approach predicated on the assumption that government officials have a monopoly on expertise and information regarding the workings of America's enormous, interconnected economy.

Apart from the problems of rent-seeking that industrial-policy advocates need to grapple with, the kinds of knowledge federal bureaucrats would have to possess in order to implement the suggested policies is breathtaking. In a 2006 paper, economists Howard Pack and Kamal Saggi laid out a list of suggested questions that federal bureaucrats would have to be able to answer in order to successfully implement the sort of industrial policy many economic nationalists now seek. For example, they would have to identify which sectors have a long-term comparative advantage, which benefit from dynamic scale economies, which firms and industries generate knowledge spillovers, and what the magnitude and direction of inter-industry spillovers would be.

This is just a tiny sampling of the types of questions federal agencies would need to confront, the answer to each of which is time-sensitive, detailed, and discoverable only in pieces by certain actors with deep and regular experience in very particular sectors. Uniting all the answers into some coherent, communicable whole is virtually impossible. This leaves us with the question of how best to approach such questions: via individuals and firms working for their own self-interest, who are heavily dependent on prices and the desire for profits to guide their decisions; or via state actors imposing blunt general directives on industry?

Perfect markets and perfect market competition do not exist, but neither do perfect regulations. The errors made in markets, though, are often rapidly correctable, at least in comparison to wrongheaded government policy. Such corrections in the market come with short-term pain, but state intervention, which spawns a system of winners and losers, tends to harden around special interests whose concentrated benefits are defended tenaciously. This process has been repeatedly documented by public-choice scholars and has led to years of lost growth for countries that pursued robust industrial policies.

For example, Marcus Noland and Howard Pack's Industrial Policy in an Era of Globalization evaluated the empirical effects of a range of industrial policies in Asian countries; such policies included trade protection, research-and-development subsidies, general subsidies, and preferential lending conditioned by productivity and capital accumulation. Their analysis largely found such efforts to be ineffective in boosting the fortunes of particular sectors.

Perhaps the most dramatic evidence comes from Japan's peak industrial-policy period, which ran from 1955 to 1980. Various teams of researchers failed to find much evidence of sector growth owing to protection, taxes, subsidies, or loans. Economists Robert Lawrence and David Weinstein concluded, more specifically, that total factor productivity growth in Japan was positively correlated with competitive tax rates and imports, while protection efforts were negatively associated with productivity growth. Their research seems to prove general rules respecting the drivers of economic growth.

Japan's Ministry of Finance also noted in a 2002 study reviewing the industrial policy of this period that "the Japanese model was not the source of Japanese competitiveness but the cause of our failure." This statement is remarkable considering that it criticized the Ministry of International Trade and Industry (MITI), an incredibly powerful agency of the Japanese government. The ministry's policies were believed by many top business and economic analysts in America to represent a superior approach to capitalism, but Japan's growth stagnated in the 1990s and has not returned. While Japan's industrial policy doesn't bear all the blame, the 2002 report concluded that the sectors receiving MITI aid became uncompetitive and inefficient compared to companies and sectors that were not protected by the agency and had to compete internationally. This latter group was able to independently sustain itself.

The reasons for this can be traced to basic principles regarding the difficulty of accumulating the types and amount of knowledge necessary to manage economies, and of deploying such knowledge effectively. In the Japanese case, the government struggled to aid the private sector as it dealt with high volumes of internationally traded goods subject to numerous inputs from across the globe. But this episode also reveals what Lawrence and Weinstein noted is one of the chief benefits of trade: Imports provide access to more goods, with a range of qualities and prices, all of which domestic producers can creatively combine into even better and more refined outputs. It provides a competitive spur for many companies, prompting them to improve their products and services.

BOOSTING THE BUREAUCRACY

A prime cause of the economic sluggishness that often accompanies industrial policy is the large inducement to rent-seeking that it engenders. The purpose of an economy should be to meet the needs of consumers, since consumption is the reason why we work. Industrial policy puts the cart before the horse by attempting to serve producers first. The job of consumers should not be to keep certain workers employed; the producer serves the consumer.

We are all consumers, but we are not all manufacturing workers. The need to serve the consumer is key to the dynamism and creativity that epitomizes a market economy. While meeting this need can be challenging — and the price can be steep for those who fail — a market economy nonetheless provides the best jobs program on offer. After all, the choices of consumers determine which products or economic actions will work to our comparative advantage and which will not. Through this process of discovery, investors ultimately learn where to invest, workers learn where to work, and producers learn what resources they will need to bring goods and services to the market. This is how millions of new jobs are created — jobs in industries that previously did not even exist. This is not a neoliberal conspiracy or a degraded form of American consumerism, but a crucial feature of how trade increases the wealth of a country.

Industrial policy, like virtually any economic policy, changes our focus from adhering to a general rule of serving the consumer to enforcing a multitude of rules that aid particular producers. As a result, our goal inevitably shifts to empowering concentrated economic interests against the dispersed and aggregate interests of consumers. Work and its fruits are not a privilege granted by the state, and many instinctively recoil at collusion, cronyism, special deals, and the abuse of public power for private gain. It is not clear how an industrial policy could escape such cronyism; indeed, it would almost inevitably build on the deep corruption we already face.

Changing the rules of international trade to benefit domestic manufacturing workers will likely come at the expense of a much larger group of Americans, who will be stuck with the bills resulting from tariffs, export bounties, price supports, and other subsidies to producers. It will certainly reduce our national wealth and enlarge the federal government by giving it even more power to determine domestic winners and losers. Federal spending currently comprises almost 21% of the GDP. How much more should spending increase to achieve the growth in manufacturing and other domestic work desired by economic nationalists?

We might also ask how we will rebalance our economy to favor manufacturing when that sector makes up only 8% of current employment and service jobs comprise 80%. Surely "picking" manufacturing over service jobs will open up yet another avenue for the growth of government and crony capitalism. With economic nationalism, this becomes an essential defining feature, not merely an ancillary defect or bug.

TO KEEP OUR REPUBLIC

We must understand how deeply dependent our capitalist economy is on dynamic, growth-driven initiatives. We must also grasp the nature of our political institutions, and how both free markets and free government are our inheritance. We must not reshape this legacy to conform to worn-out leftist or economic-nationalist theories, which will always find popular support based on the mistaken notion that such paths are safer or more equitable.

Commerce and trade are as much a part of the American story as constitutionalism and limited government. Our country's identity profoundly shapes how we engage in the marketplace. Our constitutional order is broadly built on ensuring that we are both republican and commercial. Arguably, the only period when our nation was not engaged in international trade was during Thomas Jefferson's Embargo Act of 1807, which effectively throttled trans-Atlantic shipping for 15 months until its repeal in 1809, and which inflicted profound economic costs and created deep political and cultural rifts.

This is not to deny the most important role for government in relation to the economy: the rule of law and defense. The freedom to be a self-governing people comes with the duty of protecting the public sphere from faction and from organized interests profiting at the expense of the public. Publius noted that our "unequalled spirit of enterprise" would lead us to international trade, but also that it would require the federal union and a navy to protect that enterprise. While individuals and firms engage in commerce to increase their personal wealth, they also belong to a country that emphasizes goods apart from commerce. "Defense," wrote Adam Smith, "is of much more importance than opulence," and could even demand some restrictions on trade.

Indeed there should be exceptions to free trade to account for military and security concerns, such as those raised by China's lead in 5G broadband technology. Our national defense strategy must meet the Chinese directly with a smart and carefully tailored response. This will require, among other things, the end of wholesale technology transfers. The U.S. must confront China over any theft or espionage of American firms' intellectual property. Further, addressing the potential threat China poses may require increased amounts of defense research, and development of technology intended for military use. Any nation serious about its continued existence must have these policy conversations and make appropriate decisions regarding its military posture. If certain restrictions on trade are needed, they should be imposed. But this is a far cry from an industrial policy that would hamper the innovation and creativity that make an efficient and speedy defense possible. In the case of 5G technology, the first consideration should be getting the incentives and policies right for its commercial development domestically.

We must not give further proof to Adam Smith's remark that "there is a great deal of ruin in a nation." For American capitalism to continue, we must understand its capacities for disruptive growth while ensuring that both the federal government and the market are not tied down in a self-defeating industrial-policy matrix.

Richard M. Reinsch, II, is editor of Law & Liberty, host of Liberty Law Talk, and co-author with Peter Lawler of A Constitution in Full: Recovering the Unwritten Foundation of American Liberty (Kansas Press, 2019). This essay builds on remarks the author delivered in a debate with Oren Cass on industrial policy at the National Conservatism Conference in July 2019.


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