This is Capitalism

What is capitalism? At first, the question may seem laughable. Capitalism is so deeply American that when asked for a definition, one may think of David Foster Wallace’s parable of two young fish being asked, “How’s the water?” The natural response would be to look out at America and say, “This is capitalism.”

But a system that shapes many important questions in our lives deserves a more substantial answer. Capitalism influences how we work, how we consume, and how we think. It impacts which seeds are planted, which are watered, and which might grow into mighty oaks. Or put another way, it influences whose dreams will live and whose will die.

So, What is Capitalism?

The economic system Adam Smith characterized as the “system of natural liberty” developed into what we now call capitalism. This system gradually emerged from the concepts and philosophical groundwork laid by John Locke, Thomas Hobbes, Thomas Aquinas, Aristotle, and many others.

Capitalism is an economic system in which individuals and firms may privately own property and productive assets. The owners of those assets may organize production as they see fit. Individuals may exchange goods, services, and their labor through voluntary participation in the markets, with each person free to transact according to their means and personal desires.

In capitalism, economic decisions are largely decentralized. They are coordinated through markets, prices, competition, and the pursuit of profit or avoidance of losses. The market structures that so often define capitalism produce rich information about individual preference, desire, and interest, which allows people to transact in ways that create value for all participants.

In the natural state, these preferences and desires might remain hidden in each individual’s heart. Through the market mechanism, however, they come to the fore through an order book of bids and asks. These individual interests then aggregate into prices and quantities, which neatly characterize the ideal production of a good or service according to the entirety of society’s expressed economic interest. That is why Adam Smith described the capitalist system as guided by an “invisible hand”, where each individual who freely transacts in their own self-interest, accidentally benefits the broader public by contributing to an efficient allocation of capital and labor.

On some level, this system reflects the economic form of a proportional democracy. Each individual can vote freely in the market according to the magnitude and direction of their preferences. The system’s design also reflects a degree of intellectual humility, for what central entity could be so all knowing as to organize the lives of millions effectively?

The state plays an important role in a capitalist system by establishing property rights, enforcing those rights and contracts, upholding the rule of law, and setting monetary policy. Without this infrastructure, the capitalist system could not function. Therefore it is proper to say that capitalism proceeds forth from the state and cannot exist without the state. For there can be no private property without enforced property rights. There can be no transaction without the rule of law. And there can be no commerce without a stable currency. In practice, the state also plays other critical roles, including providing public goods, addressing externalities and market failures, and maintaining a welfare system that, according to the level of wealth in the economy, provides for the basic needs of its citizens.

A Few Flavors of Capitalism

A laissez-faire economy is animated solely by market forces, while government intervention is limited to protecting property rights and enforcing contracts.

A liberal market economy is animated primarily by market forces, with government intervention to provide public goods, correct market failures, and provide welfare for basic human needs.

State capitalism is a system in which market forces are preserved while the state itself directs business and economic activity. Often, this means seizing the means of production by nationalizing into state-owned enterprises or by directing, financing, or owning key industries.

Welfare capitalism is a system in which one of the state’s primary functions is to redistribute capital, often by serving as the primary provider of welfare for the working classes.

A Note on Capital Accumulation

The greatest critique of capitalism is often capital accumulation leads to wealth inequality. To think through the dynamics of capital accumulation, one might ask, how can I accumulate capital in a given system?

In a centralized system, you might accumulate capital by currying favor with the central planning body. The commissar or monarch might then bestow resources upon you. In the natural state, you might begin curating might and power, both to secure and protect your own resources and to accumulate additional resources through conquest.

In a capitalist system, one often accumulates assets by answering a different question. What can you build that generates the most value for others? You then go forth, build that thing, and then deliver it to those who value it most. If you are a baker who bakes the best pastries, business will boom. If you are a lawyer who provides the best legal services, clients will line up at your door and pay a premium for your counsel. If you charge too much, your competition will steal business from you as prospective clients turn up their noses at your prices. If you charge too little, you may be unable to cover the costs of running your business and will eventually go out of business. But if you deliver a quality product and charge a fair price, you have the opportunity to create value for others and keep a slice of that value for yourself.

In a well designed capitalist system, there can be a direct connection between public benefit and private gain.

Key Tenets of Capitalism

• Private property to protect what is an individual’s from the greedy and envious

• Private allocation of capital according to a person’s beliefs and desires

• Decentralized decision making allowing each human to transact in their own self interest

• Market exchange enables parties to voluntarily enter exchanges where both parties benefit

• Price signals to aggregate supply and demand for a good or service

• Competition to drive down prices and propel product innovation

• Profit and loss to determine the economic sustainability of an idea

• Capital accumulation and erosion as natural consequence for an individual’s past allocation of capital and labor

• Wage labor to allow market participants to freely exchange their labor for capital and capital for labor

• Entrepreneurship and innovation to improve productivity and outcompete the competition

• Legal, institutional, and monetary structure to provide the foundations for the system, rules for the system, and the fair enforcement of rules for all parties.

Eric Menser (MBA ‘27) hails from Stafford, Virginia. He graduated with a B.S. from the Air Force Academy, did five years as an officer in the Marine Corps, and then worked in the Office of the CEO at Palantir Technologies. He enjoys thinking deeply about value creation and sipping a Celsius in Spangler. Eric is an investor at Journey, a technology growth equity firm.