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Schooling the anti-capitalists on inequality

Published in Business Spectator (Melbourne), 7 August 2014

Roughly coinciding with the beginning of the financial crisis in 2008, anti-capitalism has enjoyed a global renaissance. The critics of capitalism may be quite diverse, but for many of them rising wealth and income inequality is a commonly shared concern.

Whether it is the activists behind the Occupy movement or French economist Thomas Piketty, author of Capital in the Twenty-First Century, their main objection is that capitalism fails to deliver prosperity for all. Instead, they claim the market economy makes the rich richer and the poor poorer.

As an economic liberal, I take issue with such statements. Not just because I believe that these allegations are largely untrue but also because they insinuate that free marketeers might even wish for such outcomes.

Nothing could be further from the truth. What economic liberals share with anti-capitalists is the goal to deliver prosperity for all. The differences lie in the analysis of the situation and the conclusions derived from it.

Incidentally, ‘Prosperity for all’ (or Wohlstand für Alle) is also the title of a classic book on the wealth-creating aspects of the market. Published in 1957, its author was Ludwig Erhard, the then German economics minister (and later chancellor). Erhard is widely regarded as the architect of West Germany’s post-War economic miracle, which turned the country into Europe’s economic powerhouse.

Wohlstand für Alle was the summary of Erhard’s economic beliefs. For his ideal system, he coined the phrase ‘social market economy’. The corner stone of Erhard’s social market economy is the conviction that the market economy in itself is social. It does not need to be made social, but it needs to be kept a market economy.

Like all free-market liberals, and probably like most economists, Erhard recognised the wealth-creating abilities of markets. He knew that markets, through the price mechanism, bring about an efficient allocation of resources. He knew that the price mechanism cannot work without competition. And he knew that the combination of free markets, flexible prices and competition will bring about economic growth and create prosperity — for all.

What makes Erhard’s social market economy ‘social’ is not the degree of redistribution. It is the wealth-creating nature of the market itself which led Erhard to proclaim the market economy ‘social’.

Unsurprisingly then, Erhard was a critic of the welfare state and of redistribution, not just for the purely economic reasons of undermining incentives to work. He was also convinced that the welfare state, through its redistributionist policies, would damage the social fabric of society; that it would hurt the very people it was meant to help by locking them into a life of dependence.

Against an all-encompassing, cradle-to-grave social security system, Erhard put forward the idea of a basic safety net. However, this social security system should never be allowed to undermine the ability of the market to function.

“It is true to say that every effective social aid will have to be based on an adequate and growing national income, which means an efficient economy,” he wrote. “Thus it must be in the interest of every organic social policy to secure an expanding and sound economy, and to take care that the principles of guiding this economy are maintained and extended.”

This insight from Erhard’s book is crucial. It may have been written in 1957, but it is timeless and applies directly to the question discussed today: how to respond to claims that developed countries are facing an inequality problem.

For many of the critics of capitalism, who are concerned about inequality, the answer is simply redistribution. This would mean higher taxes for the rich and transfer payments towards the poor.

However, taking inspiration from Ludwig Erhard, one would come to an entirely different conclusion. We would then ask ourselves how to address the problem of inequality while ensuring that markets can still do their jobs of allocating resources and creating prosperity. Indeed, one should ask why inequality is a problem for the developed world in the first place before figuring out what can be done about it.

The problem of inequality appears in a completely different light when regarded in a global context.

While there may be growing inequality within countries, on a global scale we are observing the very opposite between countries. To understand this development, it is instructive to consider a few figures.

In 1980, China’s per capita GDP was 1.5 per cent of US per capita GDP. By 2012, this had risen to 10.5 per cent. It is a very similar story in many developing economies around the world. As they became richer in absolute terms they also narrowed the relative gap between themselves and the US, the world’s leading economy.

By embracing capitalism, these formerly less developed countries have thus played catch-up with the developed West. Their productivity improved, their incomes shot up, they got richer. The unpleasant side-effect of this positive development is increased competition for workers in developed countries. Especially lower-skilled jobs experience this competition. They are the first to migrate to newly industrialising economies. It is this development above anything else that leads to the changing distribution of wealth in developed countries.

So if we want to lament the pressures on the less affluent segments of our society, we should not put the blame on the West’s rich or on capitalism as such, but on developing nations’ eager workforces. It is their competition that is making it harder for low-skilled workers in developed countries to improve their incomes.

Keeping Erhard in mind, the developed countries’ response to new competition cannot be to become more regulated and redistributionist. If implemented, such policies would only render them less competitive against their newly developed challengers. This in turn would only exacerbate the problem of inequality. It would undermine our ability to grow rather than enhance it.

To the competitive challenge by newly liberalised and increasingly productive economies, the response can only be to become more productive ourselves. On the one hand, this means economic reform. On the other, it requires ensuring that everyone has an opportunity to participate in the changing global economy.

If Erhard were alive today, I am convinced he would therefore focus on education.

For developed countries, delivering education to their populations is a prerequisite of economic success almost as much as a competitive system, free price formation and flexible labour markets were in the 1950s and still are today. Education and skills are a key ingredient for any economy that wants to be and remain prosperous in the 21st century. It is also the best social insurance policy against rising inequality. In order to have ‘prosperity for all”, we therefore need ‘education for all’ — and not more redistribution of a shrinking wealth pie.

Erhard’s insistence on the social market economy made West Germany rich after the War. His ideas could well help to keep developed countries prosperous under different circumstances today.

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