Explaining the Capitalist Crisis

Following a period of relative prosperity, the survival of liberal democratic capitalism is threatened by the prolonged economic slump that set in after the 2008 banking crisis. While neo-liberals attribute the crisis to state interventions that distort markets and undermine their inherent tendency to generate equilibrium solutions, structuralists attribute it to the inequalities, exclusion and deflationary spirals created by market competition itself. It turns out that the case for a free market system is undermined by commonly observed scale economies affecting its equilibrium assumptions; producing uneven development and inequality. In this case, it is clear that redistributive policies are a necessary technical requirement for the survival of an economic system that will otherwise be subject to deflationary pressures and intensifying social and political crises.

The survival of liberal democratic capitalism depends upon the ability of competitive markets to maximise equitable and stable economic development as well as efficiency and innovation. Their ability to do so has been challenged by ‘structuralist’ critics who have supported right or left wing interventionist ‘policies’ since the 17th century, most recently during the ‘Golden Age of [managed] capitalism’ during the 30 years after the war¹ that produced the longest period of growth with falling inequality in modern history². However, structuralism was discredited by the global crisis that began in the 1970s, and replaced by neo-liberalism; the long slump following the 2007/8 banking crisis now threatens, but has yet to undermine liberalism’s hegemonic status.

These competing claims have fundamental political and economic implications. However, they are rarely subjected to rigorous scrutiny by the orthodox liberals who dominate national and global policy-making agencies, or by radical political movements that call for redistributive policies without acknowledging the difficulties involved in doing so in market systems that have transferred key economic decisions from states to private corporations, and rule out most of the interventionist policies that produced the post-war golden age.

I have reviewed these issues in detail elsewhere³⁴⁵⁶ and will focus exclusively on the foundational arguments used by both schools here, focussing in particular on the role of scale economies in promoting uneven development. I will first set out the free market case, show how the existence of different kinds of scale economies undermine its equilibrium assumptions; identify the positive benefits of market systems, and conclude by reviewing the contradictory effects of market systems on economic stability, inequality, exclusion, state fragility and political conflict.

Free Markets, Economic Efficiency and Inclusive Development

Competitive markets can maximise growth, innovation and individual choice, but will only continue to do so if their benefits are evenly dispersed across the economic system, because strong firms, national economies or regions can only sell their products when their poorer customers can earn the income they need to purchase them by selling their own. This possibility breaks down when competition from strong firms or countries destroys the productive assets of weak ones by creating unemployment and import compression, where imports fall as a percentage of GDP, that imposes deflationary pressures on the system as a whole. This proposition has technical, normative and political implications, since unconstrained markets will only survive if open competition does actually generate full employment, rising wages and equilibrate demand and supply at local and global levels.

Liberal theorists accept this proposition, and argue that free markets will indeed achieve these goals, invoking Say’s law, Hume’s balance of payments theory, Arthur Lewis’ model of a labour surplus economy and Ricardo’s theory of comparative advantage to demonstrate that free trade between rich and poor communities and regions will actually benefit the latter as much as or more than the former.

Say argued that ‘supply creates its own demand’, since the income generated by wages, profits and investment must return to the market and generate the demand needed to maintain employment elsewhere. Hume showed that a country with full employment and a long-term export surplus must increase the demand for and cost of labour and assets if it invests its gains at home, and thus reduce their international competitiveness and increase imports from deficit countries. Lewis showed that free mobility of capital would allow capitalists to move their investments from rich countries with high-wages and full employment to poor ones with low wages and a labour surplus. Ricardo showed that weak countries with high costs of production would benefit from free trade by trading with more efficient lower cost countries since each could expand the production of their lower cost product, export the surplus to their neighbours and reduce production of their higher cost product and import the shortfall³.

These claims cannot be ignored, since they explain why capitalist markets have revolutionised production in late-comers as well as first-comers, most dramatically from the north to East Asia over the past 50 years.

Scale Economies, Market Failure and Uneven Development

The Say/Hume/Ricardo/Lewis model is logically consistent, but depends on problematic assumptions, notably the existence of full employment, which depends in turn on the existence of constant or diminishing returns to scale, that is to say the tendency for the costs of production of any good to rise rather than fall as output increases. Scale economies do dominate the global economy, however, undermining the equilibrium assumptions of neo-classical theory as Marx and Schumpeter showed. They operate at the plant, firm, and regional levels, and different practical consequences at each level.

First, costs of production depend on the ability to achieve levels of output determined by best-practice technology in a particular plant. Costs rise unless new technologies are introduced once a plant reaches its maximum capacity. This creates the need for more plants if demand increases, as the Say/Hume/Ricardo/Lewis theory predicts. Free markets for information, capital and commodities enable these plants to move to new areas, facilitating the emergence of new industrial centres and rapid growth in new NICs (newly industrialised countries), as we have seen.

However, new technologies like steam power or automation enable dominant producers to increase output, reduce costs and jobs, destroy or marginalise existing producers, as well as their skills and organisational systems, and existing distributions of wealth and power. This undermines the equilibrium assumptions of the Say/Hume/Ricardo/Lewis theory because lower cost firms and surplus countries can invest their profits in improved technologies and higher local production, rather than increasing imports or exporting capital. These processes of ‘creative destruction’ explain the major increases in wealth and changes in the location of industry that began with the industrial revolution, but also its disruptive and unequalising effects.

Second, global corporations benefit from scale economies derived from their superior access to research, credit, marketing and supply-chains that give their subsidiaries or suppliers a competitive advantage over single-plant firms. This facilitates the transfer of best practice technology to LDCs (late developing countries) and their access to export markets. However, it further marginalises small local producers, not only in the regional centres where TNCs (transnational corporations) do invest, but especially in the much larger regions that they ignore.

Third, plants or firms depend on the quality of local services provided by other local firms, and the ability of local states and civic networks to provide the security, human and social capital and infrastructure needed for successful production. These ‘economies of aggregation’ or ‘clustering’ not only support large firms and plants, but also enable less efficient producers in well-endowed regions to out-compete better-endowed firms in weaker states and societies.

Economies of aggregation are location-specific, built up over generations and can only be replicated or changed with great difficulty. The first-comer benefits gained by the west during the early capitalist revolution still provide them a structural advantage over most late-comers, and explain the still widening gap between the richest and poorest societies, the increasing shift of population from rural to urban areas, and the desperate attempts of economic migrants to enter developed countries. This also explains the key role of civic and political institutions in determining the economic competitiveness of plants and firms in strong and weak regions, and the tendency for open markets to encourage the flow of resources from poor to rich regions rather that rich to poor ones as liberal theory predicts.

Thus it is clear that scale economies have actually driven the dynamic processes that have transformed the modern world, allowing strong firms and countries to increase output and reduce costs and employment. When this is the case ‘the basis on which economic laws can be constructed is therefore shorn away’, as Hicks (1946)⁷ proposed, undermining the equilibrating assumptions of Say/Hume/Ricardo/Lewis theory, and ensuring that open markets promote a long-term tendency towards inequality, exclusion and crisis, and not even development..

Maximising the Benefits of Market Systems

This proposition does undermine the equilibrium assumptions that justify neo-liberal policies but it does not justify a rejection of market systems themselves. Paradoxically, the ability of free markets to facilitate the scale economies derived from science-based technical change is their greatest strength as well as their greatest weakness as Schumpeter (1943) showed. Perfect competition with diminishing returns will minimise profits and investment opportunities, and reduce growth; oligopolistic competition based on scale economies has forced through all major technological transformations – the introduction of fossil fuels, mass production and real time communications. This has produced immense wealth in successful regions and real gains almost everywhere, but also growing inequalities, balance of payments disequilibria in weak countries, as well as environmental degradation.

Thus our crucial task is not to eliminate markets, but to turn them from bad masters into good servants by safeguarding the immense benefits generated by discontinuous technical change while protecting its victims from its destructive consequences. We must therefore first identify the market-driven processes that do offset uneven development, then the redistributive interventions needed to universalise their benefits.

Increasing returns generate uneven development unless they are offset by ‘countervailing effects’:

• scale-reducing technological changes like computers and mobile phones enable small or new companies to challenge established producers when the latter do not enjoy monopoly powers. Increased demand generated by growth in the high-technology sector increases demand for services and inputs produced by small firms and informal service providers, as Say’s law predicts.
• the recent shift of industry from rich to poor countries in response to falling protectionist barriers in the north and lower costs in the best organised Late Developing Countries have redistributed industrial capacity as Lewis predicted.
• scale economies generate the surpluses and release the labour that governments and solidaristic movements need to finance safety nets and social services and provide people with the leisure they need to enjoy a growing range of cultural activities.

These immense benefits derived from open markets will also be undermined by inappropriate interventions by predatory or weak states, and by perverse policy programmes like command planning (whereby decisions regarding production and investment are made by a central authority), populist redistributions, unsustainable deficit financing or protectionism leading to under-valued exchange-rates in surplus countries or that block the price adjustments needed to overcome long-term trade deficits.

Managing Uneven Development

These benefits explain the hegemonic status of market theory, but they do not protect the system from crises they impose on weak states and global system. These include:

• chronic balance of payments disequilibria between surplus and deficit countries, with rapid growth and reserve accumulation in the former, import compression and fiscal deficits in the latter, and deflation in the world economy as a whole;
• a growing army of un- and under-employed labour subsisting in the ‘informal’ or criminal economy in the poorest societies, and benefit-dependent underclass in the richest ones, created by high barriers to entry for infant industries and the destruction of vulnerable companies in pre-industrial and industrialised regions,
• intensifying economic and political stresses in fragile states whose capitalist economies are too weak to finance internationally competitive infrastructure and services, and in middle income countries whose old industries have been destroyed by low-wage imports, but lack the skills and tax capacity to build the skill-intensive industries needed to compete with the strongest countries;
• and, unsustainable environmental degradation and loss of biodiversity stemming from market-driven need to adopt least-cost production processes¹⁰.

Thus accelerating technological change and improved services in strong regions has enabled the strongest countries, top elites and better educated strata to make spectacular gains, but have destroyed jobs and generated fiscal and balance of payments crises elsewhere. Better governance and rising raw material prices have increased growth in some poor countries, but their benefits have been unevenly distributed, creating an underemployed global underclass dependent on marginalised and often criminal activities.

Their plight and the intensity of the crisis would be far worse but for the residual effects of the welfare programmes introduced during the social democratic period, and many emergency measures – International Monetary Fund and European Union austerity programmes, quantitative easing, massive deficit financing in the USA and state-led infrastructure development in China – whose redistributive effects have reduced deflationary pressures and sustained social cohesion.

However, they are expected to facilitate a return to liberal policies that are not reversing the cumulative effects of unregulated international competition, have imposed devastating cuts on the poor, and allowed the rich to escape virtually unscathed. The aid industry is supporting poverty reduction programmes based on pro-poor services and small-business development, but they are underfunded, subverted by political corruption and bureaucratic failure, and undermined by cheap low-wage imports.

We cannot review detailed solutions here, merely identify some key implications of this analysis:

First, the dynamic and potentially disruptive consequences of market-driven scale economies have fundamental policy implications because they mean that redistributive policies are not an optional extra driven by a moral commitment to equality and poverty alleviation, but a necessary technical requirement for the survival of an economic system that will otherwise be subject to deflationary pressures and intensifying social and political crises. Liberal theorists treat state regulation as a mechanism that exists to enable markets to operate with minimal constraints, and redistributive policies as emergency mechanisms designed to overcome what are seen to be short-term fluctuations usually caused by inappropriate interventionist policies; social democrats believe, with good cause, that they are essential if we are to control what Polanyi called ‘the weaknesses and perils inherent in self-regulating markets’⁸.

Second, chronic surpluses in strong countries, and complementary deficits in weaker ones must continue to produce import compression and international deflation without stronger global redistributive mechanisms and pressure on strong countries to reduce their surpluses. The International Monetary Fund and International Trade Organisation are dominated by surplus countries, and provide deficit countries with limited support in exchange for neo-liberal austerity programmes that reduce demand and enable surplus countries to increase their exports. The need for a global system that would enable deficit countries to address the supply constraints generated by free trade were actively debated in the 1940s raising issues and possibilities that should be revisited now³⁴⁹.

Third, many post-war statist policies cannot be repeated, but immense accumulations of capital and knowledge do exist that could be used to develop labour intensive green investments that would alleviate the immiserisation, political instability, and environmental degradation created by the current economic order. This would require a social democratic movement that could capture power and implement a green and global programme despite the ability of dominant elites to control national and global political processes, the decline of the industrial working class that sustained the statist socialist project, and their replacement by right-wing nationalism and populist anti-austerity movements that fail to recognise both the weaknesses and strengths of the market based system that is reproducing the current crisis.

This is a daunting task, but we ignore it at our peril.