| The capitalist engine is first and last an engine
of mass production which unavoidably means also production for
the masses. . . . The capitalist achievement does not typically
consist in providing more silk stockings for queens but in bringing
them within the reach of factory girls for steadily decreasing
amounts of effort. - Joseph Schumpeter |
The purpose of this chapter is to examine how modern capitalism
functions: to dissect this economic system in order to understand
its basic structure and mode of operation. This is necessarily
abstract -we will examine 'Modern Capitalism in General' rather
than any particular form or era of modern capitalism. Modern
capitalism, at least for the purposes of this chapter, starts
with the completion of the ripening process described in
Chapter 9.
Before dissecting modern capitalism, it will be helpful to review some of the steps along the route to see how both capitalism and our understanding of it have evolved.
We had started with the type of small business capitalism described and analyzed by Adam Smith and David Ricardo. Most 'capital' was simply the money needed by the capitalist to pay for labor and raw materials before being paid for the final product. The banking system was only partially developed and many capitalists funded their operations directly out of profits or by direct borrowing. Income took the form of wages, profits and landrent and it was spent on consumer goods and business expansion. Capitalists were competing with landowners for their share of the social surplus. The flow of output grew as capitalists increased the division of labor. The division of labor could increase with the extent of trade. Trade could increase as internal barriers to trade, such as guild rules and local government tolls, and external barriers to trade, such as tariffs, were eliminated or reduced by an increasingly enlightened government. Wages would stay close to subsistence: higher wages would be accompanied by rapid population growth which would bring wages back down; lower wages would be accompanied by declining population growth which would bring wages back up.
Next we added a more fully evolved banking system to the flow of output and money. By making it easier to both save and borrow, the banking system further separates total demand from income. By making it easier to fund business expansion through borrowing, the banking system ties investment closer to future profits (from which the loans and interest will be repaid) and makes investment less dependent on the past accumulation or present flow of profits. This change was accompanied by a greater role for fixed capital in the form of specialized equipment and buildings rather than operating capital in the form of funds to pay for raw materials and labor.
These changes also made capitalism more crisis-prone. Competition
among capitalists drove them to invest. But they invested, for
the most part, in factories which would produce wage goods. And
the relentless march of technology meant that an ever-growing
part of their investment was for fixed capital. Yet the
worker's wage was still close to subsistence. If rapid growth
of employment threatened to force wages up the capitalists would
dip into the reserve army of the unemployed. When the
ranks of this labor reserve were exhausted, the capitalists would
add new machinery at a more rapid rate, thus increasing productivity,
tossing workers onto the streets and eliminating the pressure
for higher wages. Disparities among the production sectors, overinvestment,
underconsumption, and - perhaps - a trend toward falling profits
as machines replaced workers turned the growth process into a
sequence of crises.
The transformation that occurred when the industrial revolution reached its "ripening" phase was examined in Chapter 9. Wages rose above subsistence levels and neither population growth (as in Smith and Ricardo's theories) nor labor-saving capital investment (as in Marx's theory) drove them back down. Thus began the modern stage of capitalism.
Our starting point for analyzing this stage of capitalism is to examine the flow of income and expenditure. As before, the arrowheads on the charts point in the direction of flows of money. Chart 1 presents a simplified version of the flow: production requires payments to workers (and others) which constitute their income; income, in turn, provides the basis for demand; demand is the purchase of the goods and services that are being produced. Note a major difference from the previous charts (in Chapter 9). Under conditions of subsistence wages, workers necessarily spent what they earned, so wage-income and demand were in the same box. Once we entertain the possibility of wages rising above subsistence levels, we also open up the possibility that wage-income will not always be quickly spent. So the charts that dissect modern capitalism separate income from demand.
The interrelationships among these three facets of economic life -production, income and demand - will determine whether an economy prospers or stagnates. In a robust growing economy increasing production will lead to a larger stream of wages and salaries. Higher wages will spur greater demand; greater demand assures firms that they can continue to increase production. Even this simple chart can demonstrate that all three facets of the economic flow have to grow together: production depends on demand; demand depends on income; income depends on production. Any economic event which affects one of the three will affect all of them.
The next step is to add several crucial elements of the real economy to the flow chart. Chart 2 divides the flow of income into two streams: wages and profits. It also identifies investment as a special category of production. Just as most wage income will be used to purchase consumer goods and services, most profit will be reinvested.
Government is treated here like just like a business firm. It produces public goods. Even though these are paid for through taxation rather than sale, we can consider taxes to be part of the money flow from demand to production. While government does not earn profits, it buys goods and services from private firms and these purchases generate both wages and profits. And the wages that government pays to its own employees become part of the wage stream. Government can also borrow and invest, as, for example, when a school district issues bonds in order to build new schools. A later chapter will specifically examine government's role in steering the flow of production and income through the economy, but for now government does not need to be separated from private firms.
This chart helps identify some of the characteristics of modern capitalism that are not visible in the simpler chart. There are two distinct forms of spending: consumer spending and investment spending. And there are two distinct forms of income: labor income (wages and salaries) and property income (profit). If all income went to wages and all wages were spent on consumer goods and services, there would be no investment and therefore no growth. On the other hand, if too much income went to profit and too little to wages, low demand for consumer goods and services would make investment unprofitable and there would be no investment and therefore no growth.
We can't have modern capitalism without banks. The financial system is added in Chart 3. The banking system makes it easier for us to siphon some of our income out of the flow of spending: workers might save out of their wages and capitalists might save out of their profits. The banking system also makes it easier for us to spend more than our incomes: banks can make consumer loans which increase consumer spending and business loans which increase investment spending. Keep in mind that banks create money when they make loans and that this process is self-expanding as the loans themselves become bank deposits and provide the base from which more loans are made.
The banking system also churns money around. Capitalists can borrow what the workers save and workers might borrow what the capitalists save. So a decrease in investment spending by firms might possibly be offset by an increase in consumer spending financed by borrowing. Or the pension-fund savings of thrifty workers might be borrowed by firms and spent on business expansion.
One more addition must be made to the flow charts before we have a completed picture of modern capitalism. So far, we have been operating on the simplifying - but unrealistic - assumption of an economy closed to foreign trade. Chart 4 simply overlays Chart 3 with some of the linkages between a national economy and the rest of the world. The shaded arrows represent the international money flows.
Start with consumer demand. Some of your wage income will be spent on imported goods. These purchases represent a leakage out of the flow from consumer demand to production in the importing country; of course they also add to the flow in the exporting country. But we export consumer goods as well, redirecting some of the flow from consumer demand in the importing country toward production in the exporting country.
Foreign trade is not limited to consumer goods and services. Capital equipment and business services are also imported and exported. The sum of all trade (adding all exports and subtracting all imports) is called the balance of trade. A country whose exports exceed imports has a trade surplus; which increases its production/income/demand flow. A country whose imports exceed its exports has a trade deficit; this decreases its production/income/demand flow.
There are other international flows as well. Banks in one country
may make loans in other countries. Firms in one country may invest
in other countries. By the last quarter of the 20th century,
most large firms were operating on a global scale. Capitalists
will invest wherever they think they can get the highest return.
Corporate financial officers will park their spare money wherever
they can get the best combination of yield, security and liquidity.
Production and investment in a capitalist economy are propelled by the quest for profits. Profits are simple enough to define: revenue minus costs. If a firm can produce goods or services which bring in a revenue greater than their costs, it makes a profit. If the costs are greater than the revenues, it suffers a loss. While the firm's owners might be willing to endure a temporary loss (due, perhaps, to a contraction of demand during a recession), if all they can see in the future is more loss, they cease to produce.
Revenue depends on the ability and willingness of customers and potential customers to buy the product. Economists use the word "demand" to describe this ability and willingness. But demand in turn depends on a number of different factors. Some of them are subject to control or influence by the capitalist. The capitalist can control the design and the quality of the product. The capitalist can advertise in the hope of altering consumers' tastes. The capitalist can also affect the customers' ability and willingness to buy by lowering prices.
But there is one element of demand which the individual capitalist is powerless to change. This is income. Even a company as large as General Motors will find only a minuscule portion of the demand for its products coming from its own employees and stockholders. Thus raising their wages and/or dividends will not greatly expand the demand for General Motors' automobiles.
Costs are determined by the prices of the things the company must buy or rent in order to produce its products, and by the production methods that are available to convert these things into salable goods or services. The most significant of these costs is the cost of labor. Even a firm that does not use much direct labor must buy its raw materials, subcomponents and services from firms that do. In the United States, wages and salaries make up about 75% of all costs. An increase in wages, then, can potentially reduce profits by increasing costs.
Yet wages and salaries also make up the bulk of income--between 75 and 80 percent in the United States. So wages are a major element of demand. A few favored firms can profit by selling luxury goods or services to the wealthy, but most firms depend on the purchasing power of the middle and working classes. High-wage industrial workers in the rich countries buy more goods and services than low-wage industrial workers in poor countries. A Brazilian auto worker's $2.00/hr wage may draw the envy of a US. auto firm's accountant, but the US firm's marketing manager will point out that the Brazilian auto worker commutes to work on a crowded bus.
So wages really present a contradiction. Directly or indirectly, wages make up the bulk of a company's costs. Yet the wages paid by other firms in the same economy provide the bulk of the company's revenue via their effect on demand. Consequently, rising wages (a generalized wage increase throughout the economy) improve profit opportunities through their effect on demand even as they threaten profit opportunities through their effect on costs. [1 Note]
Wages, then, have to be the "right" amount, high enough
to provide a mass market for mass-produced goods and services,
but not so high that all profits are eliminated. If wages are
at the "right" level, the simple economic flow can proceed.
Demand stimulates Production; production "produces"
income along with the goods and services; income, in turn,
is the basis of demand.
There is, however, no guarantee that wages will be the "right" amount. Labor markets do not "clear" themselves of surpluses or shortages in the same way that commodity markets do. If there is a surplus of new automobiles, for example, manufacturers will reduce output until the excess inventory returns to a manageable level. If there is a shortage of new automobiles, manufacturers will schedule more overtime or add another shift in order to take advantage of the high levels of demand. But the automobile is a commodity that is produced for sale. The worker is not. People do not normally base their family-size decisions on the expected earnings of their future children.
The supply of labor sometimes adjusts to wage decreases in the wrong direction. Low wages might drive each family to offer a greater amount of labor to employers. We can see this most clearly in cases where only one family member was working at a union plant, was laid-off, found another job at much lower pay, and a second family member sought employment in order to maintain their standard of living. It is easy to understand how dangerous this situation can become. When falling wages actually cause the number of workers seeking employment to increase, wages can fall further, bringing more people into the labor market, further wage cuts, and so on.
Wages and productivity are linked in two ways. First, changes in productivity can affect wages. Rising productivity makes it possible for wages to increase. However, whether wages will increase with productivity or not depends on labor market conditions. To use the language of logic: increasing productivity is a necessary but not sufficient condition for increasing wages. Two conditions must be present in order for wages to increase: productivity must be increasing and unemployment must be low.
Second, wages can affect productivity. Rapidly rising wages will lead to the substitution of labor by machinery. And falling wages will make employment of the latest and most productive capital equipment less essential. Thus wages affect productivity as the cost of labor changes. Increasing wages also increase demand - when firms build new factories to meet the rising demand the new factories are usually that latest model and achieve higher productivity than the firm's older factories.
Two features of a modern economy need to be noted here. First, at any point in time, firms will have a mixture of capital equipment of many different ages. Very little of the equipment in use will be the latest model. Second, capital equipment is rarely "worn out" in a technical sense. Instead, it becomes uneconomical as economic and technical conditions change. In 1995, Bethlehem Steel closed a steel mill that had been built in 1907. Much of the original equipment was still operating. Lack of demand for the mill's large girders was the major reason for closing. [2 Source] Usually, technical conditions change as new generations of machines become available which (generally) increase the amount of output per hour of labor. Economic conditions change as wages rise (or fall) and as interest rates rise or fall.
This can be illustrated with a hypothetical example. With a firm's existing machinery, a work crew of 8 can produce 50,000 refrigerator doors per year. The existing machines are paid for. If replaced, their scrap value would just cover the cost of removal. Improved machinery is available for $200,000. The new set of machinery will only need 7 workers to produce the same output that the existing machines produce with 8 workers. Maintenance costs are estimated to be the same for both the existing and the new machinery.
Should the firm buy the new machines? In order to answer this question, we need to know the wage rate, the interest rate, and how long the firm's managers think it will be before the new machinery becomes obsolete. With labor costs of $20,000 per worker per year, a 7.0% interest rate, and expected economic life (which is also the appropriate time over which the machine should be paid for) of 15 years, the existing machinery is worth keeping. Labor costs of $160,000 ($20,000 for each of eight workers) plus no machine payments beat the option of labor costs of $140,000 ($20,000 for each of seven workers) plus machinery payments (which must include interest) of $21,958.92. More simply, would you pay $21,960 a year for a machine that reduces your labor costs by only $20,000 per year?
Now introduce increasing wages into the picture. With high demand for its products and a low unemployment rate, the firm had to increase its wages (in real terms) by ten percent to $22,000 per worker per year. At these wage rates, the $21,960 per year cost of the new machinery looks more attractive.
It is important to keep in mind that productivity, from the perspective of a company, is a means to an end, not an end in itself. The company's goal is to increase its profits. Under certain economic conditions, the best way to do this is through increasing the productivity of labor. Under other economic conditions the lower-productivity production methods will be the most profitable.
By changing our perspective, however, we get a different picture.
While increasing productivity is not always in the interest of
an individual firm, it is always in the interest of the overall
economy. It is the basic way in which we get richer. Improvements
in the productivity of labor allow us to have more goods and services
with less work. From 1950 to 1970, for example, output per hour
of work in the United States increased by 63 percent. This allowed
us to increase consumer goods produced per employed person by
43 percent even while the average work week fell by 7 percent.
But increased consumption and a diminished work week did not
deplete the entire increase in productivity; we were also able
to increase our production of public goods (parks, schools and
roads, for example) and produce more of the capital equipment
that would contribute to further increases in productivity.
Having laid the foundation, we are now able to follow the path of a hypothetical phase of self-sustaining economic growth. This path is identified in Chart 5. As in other charts, the white arrows represent money flows. But the shaded arrows do not: they indicate cause and effect linkages.
The story told above is a pleasant one. And it occasionally occurs. It partially describes the US, western European and Japanese economies during the 1950s and 1960s. But the reader should note how many favorable conditions are required for growth of this type to ensue---now we will look at the many opportunities a modern economy has to stumble.
This simple tour through some of the basic interconnections of
a capitalist economy leads us to at least two conclusions; conclusions
which contradict much of our traditional thinking about economic
growth. First, there is nothing normal or inevitable about economic
growth. Long periods of self-sustaining economic growth require
a rather remarkable conjuncture of favorable conditions. It should
not be surprising that such periods are indeed rare. Second,
the neoclassical economists make quite a big deal about the supposedly
"self-correcting" forces that will put a slightly ill
economy back on its feet. However, when we look at the overall
market for human labor, which is one of the most important elements
of our economic well-being, the self-correcting forces are at
best absent and at worst act to exacerbate rather than ameliorate
the obstacles to economic growth.