Capitalism is good. Let me explain. (Patreon)

[This is a transcript with links to references.]

Capitalism will kill us all. That is, if you trust Greta Thunberg. Which maybe you should not. Free markets will save us all. If you trust Robert F Kennedy, junior. Which maybe you should not. Maybe we should talk about what capitalism and free markets are. Will they kill us or save us? That’s what we’ll talk about today.

Before we talk about capitalism and markets and stuff, we need to talk about money. I don’t mean my money, though while we’re at it, check out my Patreon. I mean money in general.

What do we even need money for? Suppose you have an apple, but you’d rather have an egg. You ask your friend Sue, the one with the chickens, and trade and egg for an apple. Ok. But what if Sue doesn’t want an apple, she’d rather have a banana?

No problem, you ask your friend Joe with the bananas if he will trade your apple for a banana. Then you trade the banana for Sue’s egg. Ok, but what if Joe doesn’t want an apple either, he’d rather have new shoelaces. No problem, you ask your friend Mary if she’ll take an apple for shoelaces, give the shoelaces to Joe, take the banana, give the banana to Sue and sure enough you have your egg.

It works, but honestly, that seems a little cumbersome. How about we instead trade something that everyone will accept because they can exchange it for something else later. Like, gold maybe. I give some gold to Sue, and she gives me an egg. Then she can take the gold and give it to Joe and get her banana. That’s much easier. Hurray, we just invented commodity money!

Alright, but now imagine you don’t want to buy an egg, but an entire chicken farm. That would be a lot of gold you’d have to wheel around. So how about we instead, I dunno, print the face of a king onto a piece of gold and say it stands for an entire cart of gold. Come to think of it, why bother with gold, let’s just print it on a piece of paper. The paper itself doesn’t have much of a value, but if we all agree on what it stands for, we can use it for trade. Hurray, we just invented token money!

That sounds great, but the problem is, if a lot of vendors just refuse to accept this money, it stops working. So in reality token money is backed up by a king or government which enforces that vendors accept the money as payment. It’s then called “fiat money”. Almost all money we use today is “fiat money,” except cryptocurrencies, but that’s another story...

Fiat money is fascinating, because it’s ultimately still based on trust. If all you guys watching this video freak out, exchange your entire US dollars for Euro, and tell your friends to do the same, the US dollar would collapse. So don’t do it.

Several economists have argued that any community of sufficiently intelligent traders will eventually introduce a type of token money because it’s the most efficient way to distribute resources. This idea was maybe first clearly formulated by the Scottish economist Adam Smith.

Alright, so we have money, but our busy traders still have a problem. Suppose you have a lot of apples and not sufficiently many people to buy them. Your amazing apples rot away, what a shame. You would like to make apple juice from them, but you can’t afford a juice press, so your breakthrough innovation doesn’t come into being. That sucks.

However, your friend Sue has been getting really rich with all her chickens. So rich in fact, she’s sitting on a big pile of money that she doesn’t know what to do with. Sue sees your problem and offers you a deal. She gives you some of her money, so that you can buy your juice press. You just have to agree that if you get rich with your juice press, you give her the money back, plus something on top. That money which Sue gives to you is your “capital”.

And such was born the “capitalist”. The capitalist is a person or institution who provides capital to those who want to launch a new business, someone who is able and willing to take the risk that this capital will never have a return on investment.

Today, we grow up with money and banks and all, and we tend to take them for granted. And while money lending and a basic notion of financial debt date back thousands of years, capitalism and all the elaborate financial instruments that come with it, is a surprisingly recent innovation. It didn’t really take off until the industrial revolution 150 years ago and it’s dramatically changed the world.

Scientists tend to associate the stunning societal progress we’ve seen since then to science and technology, but I think that’s having it backwards. The driver of all this progress was the capitalist system that allowed an efficient allocation of resources. By resources, I don’t just mean raw materials, but also goods and human resources. Capitalism is a system that distributes these resources without anyone needing to have an overview, just by interactions between traders. It’s pure genius if you think about it. And that’s why science took off, not the other way round.

Remember that story about how the Scottish physician Alexander Fleming supposedly accidentally discovered penicillin in 1928, and saved the lives of countless wounded soldiers in World War II? Yeah, well, that isn’t really what happened.

First of all, scientists had discovered that the fungus penicillium inhibits the growth of bacteria decades earlier, it just wasn’t widely known. The British physiologist Burdon-Sanderson for example observed this in 1870 and wrote a book about it. There are also several other written documentations from other people around that time who had studied the effect of fungi on bacteria.

Fleming’s contribution was that he realized the fungus was shedding a particular substance, which he called penicillin. But he pretty much left it at naming the stuff.

It wasn’t until 10 years later that a group at the university of oxford set out to find a way to grow the fungus and extract penicillin in large quantities. They then conducted medical trials, and once they were sure penicillin was both safe and effective, their method was scaled up by the pharmaceutical industry. Two members of the Oxford group later shared the Nobel Prize with Fleming.

So what saved all those many lives wasn’t just Fleming’s observation in a petri dish. The game changer was producing the stuff in large quantities and bringing it where it was needed. Innovation and industrialization, ultimately going back to capitalism. That’s what saved all those people.

Capitalism got a pretty bad rep when Marx claimed that it’s just about grabbing hold of the “means of production” and “exploiting the working class”. Of course, there was an element of truth to his fears, because some things went badly wrong during the industrial revolution, but that’s another story…

For today we just need to know that capitalism, like fiat money, requires a governing institution. That’s because someone must be there to enforce contracts, should the need arise. That, and a few other things, as we will see in a moment.

There are many different ways to govern a capitalist system, and they go by different names like “welfare capitalism” or “laissez-faire capitalism” or “state capitalism”. Now, one can debate how well the actions of certain governments reflect the interests of their electorate, if they were elected in the first place, but that’s another story. Even so, capitalism has been enormously successful in unlocking societal progress, and the nations who still don’t use it, such as North Korea, Cuba, and Laos, are places you don’t want to live.

We’ve seen that capitalism is a system that combines markets with governing rules to efficiently distribute resources. This distribution of resources works best if everyone can put forward their offers freely and customers can pick what they want. This is known as a “free market,” and it optimizes the distribution of resources by competition. Free markets are a beautiful example of decentralized self-organization, an “invisible hand” as Adam Smith put it.

The way it works in a nutshell is that everyone can trade around until they’ve got what they think is the best combination of goods, services, and financial assets. If someone doesn’t use resources as efficiently as possible, some competitor can do it better and beat them off the market.

This idea also goes back to Adam Smith but later blossomed into an entire discipline now known as “microeconomics”. Microeconomics is all about how agents – that could be people or corporations or institutions – trade, and how that trade distributes resources where they are most needed. To be fair, microeconomics has some shortcomings when it comes to explaining how we trade in reality, but that’s another story… By and large, microeconomics works fine, and several Nobel Prizes have been awarded for it.

One of the most important insights to come out of this research is that free markets only work to everyone’s benefit if they are set up properly. Keep in mind that capitalism is not just a free market. It’s a free market plus the governing framework to run it.

Free markets do not, for example, work to everyone’s favour if some people have insider information which gives them a trading advantage. This is why we have laws against that. Free markets also work badly if one single company dominates a market sector and can use their power to force customers to stick with them. This is why we have laws against that.

And free markets also don’t automatically account for externalities, such as environmental pollution. An externality is generally any consequence of trade that doesn’t directly affect the trading parties. They can be both good and bad, but it’s the bad ones that are the problem.

Suppose there’s a river going by your house that everyone is free to use. One day a clothing company puts up a factory and dumps their toxic waste into the river. All the fish die, and no one dares swimming in the river anymore. This is clearly not an optimal use of resources, you might say. Why didn’t Smith’s “invisible hand” prevent it?

The reason market forces didn’t prevent it is that the water was free to use. The market didn’t know it had *any value, so pollution couldn’t reduce its value.

There are several ways to deal with problems like this. One is to just pass laws that forbid certain actions and punish those who disobey. Or you can put a tax on the pollution so that at least the government has money to clear up the mess. Or you can put a price on using the water. There are pros and cons to all of those, but that’s a different story…

The story for today is that we have known that externalities can lead to market failures since the middle of the last century. Carbon dioxide emissions are such an externality. For the market to optimize the use of fossil fuel resources, we should have put a price on releasing carbon dioxide into the atmosphere. We did not, and this is why we we’re now in deep shit.

So, yes, our current capitalist systems do have a problem with environmental protection. But the reason isn’t that there’s something wrong with capitalism per se. It’s that we didn’t set up it up correctly in the first place. Basically, the origin of the problem is that no one paid attention to economists.

And unfortunately, we still don’t pay enough attention to economists. The current situation is that companies who voluntarily produce environmentally friendly goods put themselves at a competitive disadvantage, because other companies exploit the environment at zero cost. This moves the burden onto the consumer. If you want to buy a climate friendly product today, you face extra costs, because fossil fuels are cheap and getting to net zero is not.

This makes no economic sense, and it will ultimately not work. It’s completely upside-down. Products whose production causes damage to the environment, which then requires adaption and mitigation should be more expensive, not less expensive.

This is why economists have argued for decades that we need to put a price on carbon, and it’s why several countries have now introduced carbon taxes, or use a cap and trade system. To calculate the cost of carbon emissions one basically needs to evaluate the damage the emissions would cause in the future and then put a price on them. It’s called the “social cost of carbon”. There’s a long debate about just exactly how to calculate this, but that’s another story…

At the moment, carbon taxes and trading schemes only apply to about a quarter of all emission and the price of carbon is almost certainly still too low, but it’s a step in the right direction.

In summary, capitalism has been incredibly successful in advancing society. To the extent that it has caused us problems it’s because we haven’t properly used it. The solution is not to abandon it, but to make sure it works to our advantage. There’s no simple way to do that, and everyone who claims that the solution is to either discard capitalism or blindly trust it didn’t understand the problem in the first place.