The Future of Capitalism: How to Cope With Market Failures?

The global economy has raised living standards for many millions who now take for granted opportunities undreamed of barely a generation ago. But the success story is not without its trouble spots. In fact, the very foundations upon which progress and prosperity have been built are increasingly under threat.

Governments are finding it difficult to articulate adequate policy responses to these threats, and a sense of fragility continues to erode the trust of populations in their politicians. Legitimacy is becoming an issue. Some of the policies that need to be shaped are quintessentially domestic, but the globalized nature of our economic and political structures make effective multilateralism an essential precondition of a successful exit from our present difficulties.

Determining the future of capitalism requires an effective global governance system in which multilateralism is central and a large amount of political energy is readily available. And that, in turn, requires strong leadership, which is in short supply.

International competition, where it has been allowed to flourish, has improved the efficiency of markets and fostered productivity growth. This is the triumph of the Ricardian narrative. In recent times, though, we have moved increasingly in a direction where Schumpetarian considerations have come to the fore. Without doing too much violence to the subtleties of Schumpeter’s use of the notion of “creative destruction,” we could equate his concerns about the direction capitalism would take with today’s discussions of structural adjustment.

I mean structural adjustment in the broadest sense. It is not just about managing the changing structure of production of goods and services as investment, wages, infrastructure development, productivity growth and innovation shift comparative advantage. It is also about the social fallout from the interplay of market forces.

In his book Capitalism, Socialism and Democracy, Schumpeter predicted that a major force challenging capitalism would be an intellectual backlash against corporate capitalism. But a responsible critique needs to do better than just damn the model. Realistic alternatives need to be put forward, and that feature of critical analysis is not always in ready supply.

Today, a more powerful and dangerous force than unfocused intellectual discourse is at work. It is popular disillusionment with market-driven outcomes, and also with the perceived unwillingness of governments to address adequately the well-known and well understood failures of markets.

Market failures

Markets are failing in three important ways. First, market developments over the years have generated more inequality in many countries than has been seen in a very long time. Second, unemployment has risen in many of the industrial countries to levels widely regarded as unsustainable. Third, the financial crisis that started in 2007, and threatens us still, laid bare the inadequacy of the macro-foundations of the financial system in the absence of proper regulatory supervision.

Taking the first of these market failures, one occasionally hears the argument that inequality may be a problem. But global markets have achieved something far more important — lifting many millions of people out of poverty. This achievement is, in itself, excellent news (although in the post-recession economy some of those have slipped back into poverty).

But pointing to poverty alleviation in an attempt to blunt concern about inequality does not pass muster. Growing inequality is increasingly seen simply as an unacceptable feature of market-driven economies. When the contrasts become sufficiently stark, it becomes a matter of ethics and justice.

The post-recession recovery has become sluggish and threatens to reverse itself in some countries. But overall economic performance shines in comparison to the employment record. Job creation has been an elusive and ultimately frustrated aspiration. Youth employment and opportunities for first-time job seekers have been the hardest hit. A global precariat — a “no hope, no future” generation — is in the making.

Finally, the financial crisis rapidly went global and also infected the real economy. International trade collapsed into a downward spiral, exacerbated with the shortage of trade finance. Trade has since recovered, but trade finance is still a problem given the financial deleveraging taking place.

One of the more satisfying features of post-crisis trade policy is that governments largely held the line on keeping markets open. But we are not out of the woods yet. Protectionist pressures are on the rise and protectionism could assert itself. Many of the financial practices that lead to the crisis remain untamed. The risk of another bout of global contagion led by the financial sector cannot be discounted.

Among the three market failures, the financial crisis was in many ways the one most overtly linked to the international economy. If governments are going to effectively address the other two major challenges facing a number of prominent economies (inequality and unemployment), the implementation of a series of short-term and longer-term measures is going to be necessary. Our more Schumpeterian — that is, risk-oriented — world needs stronger domestic safety nets. This must form part of the social contract, helping to underwrite acceptance of the market-based organization of economies.

In the longer term, there is no substitution for investing adequately in education. This must be a public investment, because education — like health care and other services — is not supplied in sufficiently accessible form to the population at large. The challenges of inequality and unemployment are rooted in underinvestment in education, leading to elusive opportunity and a mismatch between skills and job vacancies. It must surely be a source of deep concern that educational quality and literacy levels are dropping in many industrial economies. In addition to education, it is necessary to invest in programs promoting entrepreneurship and innovation to encourage people at all levels to create their own opportunities.

But a more Ricardian world needs stronger multilateralism. For a range of complex reasons, partly located in shifting power relationships and a lack of effective leadership, international regimes are struggling to yield cooperative outcomes.

In trade, we see this in the difficulties to conclude the Doha Round. In climate change discussions, decisions continue to be postponed into the future. In the financial sector, the lack of a coherent regulatory approach continues to undermine market confidence. These shortcomings in international regimes inhibit growth and prosperity, breed uncertainty and weaken governance.

Capitalism will not survive the legitimacy test without stronger domestic safety nets and a more effective multilateralism. And for this to happen, the starting point must be to localize global issues.

Editor’s note: This essay was adapted from the author’s presentation at the 2011 Salzburg Trilogue. Hosted by the Bertelsmann Stiftung in Germany, the Salzburg Trilogue facilitates international cultural dialogue by bringing together recognized public figures to consider matters of global importance.