PLSC 270: Capitalism: Success, Crisis, and Reform

Lecture 1

 - Exploding Worlds and Course Introduction


Professor Rae introduces the concept of capital as accumulated wealth used to produce more wealth. Questions about what constitutes capital are posed and discussed. The biggest story in recent economic history is the substitution of labor intensive production to capital intensive production. This transition, and the various speeds and scales with which it has occurred in different places at different times, has generated large income disparities around the world. Characteristics of capitalism are presented and discussed.

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Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 1 - Exploding Worlds and Course Introduction

Chapter 1. Introduction and Class Agenda [00:00:00]

Professor Douglas W. Rae: I’m going to use today to actually cover some introductory material. We will use most of the fifty minutes. The last part of today’s lecture will describe the course, its requirements, and so forth. So let’s begin. Capitalism — we’re going to break the subject today into three headings. Capital, capitalism, and course, three “Cs” if you will. The — I’ve chosen, and I usually do this, I’ve chosen one segment of the economy as the theme for the day, and today that segment is revealed in this slide. Calhoun Athletics XXL, can you interpret the slide?

Student: Green technology.

Professor Douglas W. Rae: Okay what in particular?

Student: [Inaudible]

Professor Douglas W. Rae: Okay, how about Varic bottled water?

Student: Like the crop circles?

Chapter 2. Capital [00:01:15]

Professor Douglas W. Rae: Okay, they are indeed crop circles. Score one for MBAs. They are crop circles, and all of us who travel from east to west across the country have seen them, but we haven’t seen them quite in this density because this photograph is taken from space, it’s a NASA image, and it’s an extraordinarily elegant display of something very simple. Now why would center pivot agriculture interest us from the point of view of capitalism? The mis-formatted slide here says capital. This is a definition that comes down to us through the Oxford English Dictionary from the early seventeenth century and let me read it in full and then we’ll boil it down to more manageable terms: “Capital is the accumulated wealth of an individual, company, or community used as a fund to carry on fresh production; wealth in any form used to help in producing more wealth.” And there’s a shift between those two meanings. The first is a very broad understanding of capital. The second is very close to the way you would have to think about capital in connection with an economic system called capitalism.

So, let’s start with the broader usage, “Capital is accumulated wealth used as a fund in carrying on fresh production.” That’s a very broad idea. It is one which arguably — in fact I think without much argument, goes back 10,000 years to the establishment of agricultural society, and very possibly another 100,000 or 120,000 years to organized hunter gatherers using weapons and tools. Does this qualify? Is that not capital? What do you think? Second row purple —

Student: [Inaudible]

Professor Douglas W. Rae: It is capital. Sorry, excuse me, can you hand her this?

Student: [Inaudible]

Professor Douglas W. Rae: Okay, so the nuts buried in the forest floor are accumulated wealth, so it meets that test. Does it meet the next test? You need the mic a little closer to your mouth.

Student: [Inaudible]

Professor Douglas W. Rae: Okay so what is the squirrel producing with that nut?

Student: Nothing material.

Professor Douglas W. Rae: He’s producing squirrel, and that’s not really what we mean. Hand the mic to somebody else and we’ll just — it’s the hot potato. Just pass it around and wherever it is when I ask a question that’s your turn. That’ll be good. The nest is producing nestlings, and it’s a little closer to what we mean. The beaver dam producing a working environment for beavers to carry out their business; it’s closer. Infrastructure if you will. The honeycomb that bees use. This one is actually the one that is closest intuitively to capital. Right? The accumulated wealth is the energy and silk required to weave the nest or weave the web, and the web is indeed an instrument for the work of capturing prey, but there’s no external product beyond it, so even that is not quite what we have in mind. Now how about seed? The seeds used in agriculture. Where’s the — where’s the mic right now? Fess up. Come on in guys. No, no, no. You’re not passing it off now. Okay, so do you reckon that seeds like this constitute capital?

Student: Okay, I don’t really think so, no.

Professor Douglas W. Rae: Okay and why not?

Student: Well, I guess that a seed produces a plant, but it doesn’t really — well I guess yeah, maybe the seed produces a plant, and then the plant produces more seeds and it sort of keeps generating more and more seeds.

Professor Douglas W. Rae: Is that capital?

Student: I mean it doesn’t look like it to me.

Professor Douglas W. Rae: Why not? Be exact.

Student: Well I guess that capital is sort of a never-ending way of accumulating more wealth.

Professor Douglas W. Rae: Does it have to go on forever? Don’t capitalists fail?

Student: Yeah capitalists fail, but good capitalists don’t.

Professor Douglas W. Rae: Take Mory’s, it’s a pretty good example. It’s a really good example, actually. Okay, mic please. In this bucket I’ve got two kilograms of seed. Would anybody say that it isn’t enough to count as capital? If — is one seed, is that enough to make it capital?

Student: What kind of seeds?

Professor Douglas W. Rae: It’s —

Student: I said what kind of seed is it?

Professor Douglas W. Rae: Okay, it is for growing safflower. If you elicit information from me you’ve got to give me something back.

Student: I think seeds in any quantity can be capital because each — once you plant it and if there isn’t successful pollination —

Professor Douglas W. Rae: Is the voice loud enough here?

Student: You can always use plants to produce more seed. In fact, that’s what a lot of farms do and that’s what a lot of farms get in trouble for because other companies want to control those seeds.

Professor Douglas W. Rae: Okay, so there’s a patent violation issue if I use hybrid seed to generate more hybrid seed? There may be, there’s an argument there. Okay, so quantity doesn’t matter at all? Yes.

Student: I’d say quantity matters if you’re a subsistence farmer because if you just have enough seed to feed yourself, that’s not capital that’s just keeping you alive, you’re not producing any further wealth from it.

Professor Douglas W. Rae: Okay and if I gave you just this much seed?

Student: Well if I’m not a farmer, if I have some other means of supporting myself that could be capital for a side business but that wouldn’t be for a subsistence farmer.

Professor Douglas W. Rae: You think it’s really worth having a business over twenty-six safflower seeds?

Student: Well no.

Professor Douglas W. Rae: No, I don’t think so either. What I’m driving at here is the notion of minimum efficient scale. Capital gets — a resource gets to be capital only when it’s aggregated to a scale where it can be effectively enough deployed to compete in an actual economy. Now let’s take — that’s too big a note, let’s take a dollar. Have I just given you capital or not?

Student: Technically yes, but probably that wouldn’t allow me to set up a budding business over here.

Professor Douglas W. Rae: Okay, how might it become a piece of capital?

Student: Well if somebody else gives me a dollar or more.

Professor Douglas W. Rae: Two dollars is enough for you to call it capital?

Student: No, but if I have more investors and they will be giving more than a dollar.

Professor Douglas W. Rae: Okay, so you need some aggregation or agglomeration. How do we aggregate capital in an actual economy?

Student: IPOs.

Professor Douglas W. Rae: IPOs are a big way to do it. In general, the joint stock corporation is a way to do it. How do banks aggregate capital?

Student: Deposits.

Professor Douglas W. Rae: Thousands of little deposits make big funds. Okay, so we’re getting there with capital and what I want to do now is continue the agricultural theme and see if we can relate what we’re talking about to the generation of actual wealth in society. This is called a seed drill. It is a way of planting millions of seeds in a very systematic, precise, and cost effective way. One characteristic feature of how capital works is combining different factors in the production of the same thing in an extremely intelligent way. A way that represents the accumulated experience of society and when you do it well you succeed, and when you do it poorly you fail. You can actually fail even when you do it well, but you’re very unlikely to succeed when you do it poorly. Now here I want to compare two very similar technologies, this is a peasant farming in Tibet and the mode of power here is a pair of yaks, and this is a John Deere tractor and the spectacular difference between these two things is obvious to us all. It is that one of them is — constitutes a large investment of capital. In the case of that tractor and the gear with it well over $100,000 must be invested. The yaks, well I don’t know what yaks cost in Tibet, but less.

We would say that the John Deere photograph represents something that’s capital intensive and the yak photograph represents something which is labor intensive. We would expect a much higher return in food generated per hour of labor invested from the highly mechanized capital intensive story. In the history of the world in the last thousand years is essentially the history of substitution of the right hand picture for the left hand; of capital intensive, highly mechanized means of production in the place of labor intensive, low capitalization means of production. Another comparison, the capital intensivity here, the ratio of that watering cans capital cost to the center pivot that might be as much as 500 meters long would be measured in the thousands to one, the tens of thousands, the hundreds of thousands probably; enormous difference in the level of investment.

Also those of you who are interested in the environment, and all of us should be, there is a huge difference in environmental impact. The labor intensive agriculture essentially leaves the environment unchanged, whereas, this kind of agriculture practiced in — it’s now a world — center pivot irrigation is a worldwide technology. And in many places it draws so much water so fast, and so much water is lost to evaporation, that the underlying aquifer is rapidly being depleted. Here are two center pivot photographs, and they too differ in capitalization. The one on the left is from Egypt, the one on the right is from Iowa, and the difference between them in the cost of the land would be dramatic. The market price of highly productive loam soil in one of the three or four richest agricultural zones in the world is much higher than in the margin of the world’s largest desert. Here’s another — I kind of got carried away with center pivot agriculture.

Here’s another slide of the same kind from the same source, and this is in Southern France. Who’s been to Southern France? Pretty great isn’t it? I have many reservations about French politics but Southern France is one of the nicest places I’ve ever been, and this summer — we’ll meet a guy here in a month named Paolo Zannoni, who is a robber baron Goldman Sachs partner, and he just built a villa overlooking Cannes in Southern France, and I had to be taken away by security. What’s striking about this photograph in comparison with the others — what’s the dramatic difference between this one and the Egyptian one, and the Iowa one? Purple? That’s not what I’m fishing for guys.

Student: There’s other things in the middle.

Professor Douglas W. Rae: Okay you got to talk really — where’s — do I have the mic? Here it is. Would you please pass this over to him?

Student: There’s other things in the middle of the green and purple circles.

Professor Douglas W. Rae: Push the on button and it’ll be on.

Student: Alright, there’s other things in the middle of the green and purple circles.

Professor Douglas W. Rae: Okay, and what are the other things?

Student: I can’t tell if they’re houses or —

Professor Douglas W. Rae: Well what are all these little polygons? Look at the right margin, for example. They are — take a guess, they’re not soccer fields. Who wants to take a guess at this? Yes.

Student: Pasture.

Professor Douglas W. Rae: Pasture? Okay they might be pasture. What they are more generally — you have the — we’ll get better at this microphone thing as we go. What they are is very small farms. They’re farms where the leaps and bounds trace back perhaps 800, 1,000, 1,200 years. They were farms which worked economically when the world was less developed in capital intensive agriculture, but they have been rendered marginal by the transformation of world agriculture. Now the question for you — are you ready for a policy question? Okay, your name is now Sarkozy, and the question is, should we increase — let’s suppose that 20% of these farms are failing a year, and we’re already subsidizing them pretty heavily. Should we subsidize them more so that the rate at which they close down is diminished? Mr. Sarkozy?

Student: I would say if you really want to effectively decrease the rate at which they’re failing you’d want to encourage consolidation. It looks like the problem here is real fragmentation.

Professor Douglas W. Rae: Okay, the problem is fragmentation, that’s a really good start. Now the person immediately to your right is your political consultant, and she’s going to tell you whether what you just said is going to wash in Lyon or not. How’s the Sarkozy consolidation program, how’s that going to play?

Student: Can you repeat the question?

Professor Douglas W. Rae: Okay, Sarkozy just said these little fragments of land are an extremely inefficient way to do agriculture. He/she was right on that point. She goes on to say that we should try to capture the scale economies of big fields by consolidating agriculture. Now you are a public official subject to election. What — how is that going to read for you, that statement that we should announce the Sarkozy Agricultural Consolidation Plan?

Student: I don’t think that the public would like it, like the small farmers.

Professor Douglas W. Rae: The small farmers would hate it, and do the small farmers play a special role in the life and imagination of France?

Student: Yes.

Professor Douglas W. Rae: Yes. Okay so probably it won’t happen and France — this is a characteristic fact about all the capitalist democracies is that pressure groups play an enormously important role in actual policy. The one book, which is available for purchase at Labyrinth, but which isn’t actually required, is Christopher Buckley’s Thank You For Smoking. How many of you have read this book?

Student: Probably watched the movie.

Professor Douglas W. Rae: Pardon?

Student: The movie.

Professor Douglas W. Rae: Oh, the movie! How many of you have seen the movie? Books! It’s all about the biases of pressure groups and public relations in the capitalist — in the largest capitalist democracy, which is our own. I just couldn’t resist throwing this one in, this is the Libyan Desert and center pivot agriculture plus maybe something else that uncles — observers from the sky found interesting. Okay so a general theme here, Strategy A / Strategy B. Strategy A is labor intensive production. Strategy B is capital intensive production. The single biggest story, and I’m repeating myself here because it’s such a big point, in recent world history is the substitution of Strategy B for Strategy A, and that happening on an extremely uneven basis. It’s happening in a big way and fast some places, and in a little way and slow other places, and that generates an enormous vertical dimension to the world. There are income ratios between households measured in the millions, millions to one, and that provides some of the interest in the functioning of capitalism which brings us to the subject.

Now comparing labor intensive, the red arrow, with capital intensive, the blue arrow, we have here a very simple production function where labor expended is on the horizontal axis, and units produced is on the vertical. For those of who are actually taking this course, these slides I posted them just before class and so if you — you can just — you don’t have to write this stuff down. If you project differences in rates of return over long periods, here I’ve put 100 production cycles, and one curve is increasing at 1%, the red one, the other is increasing at 4% per cycle, and by the end of the period there is a monstrous difference in the rate at which they are accumulating.

In actual fact very small differences, I’ve greatly overstated them in the production function here. The difference between 4% and 3%, or between 2.5% and 1%, are enormously consequential when projected over time. And at a given moment in time, are enormously consequential from a competitive point of view, because if you are not the low cost producer, the low cost producer is in a position where if she has sufficient scale of operation, she can drive you out of business. Now everything we’ve said so far could be true of almost any economic system. I put the grass here to suggest Tang, China. This was one of the great periods in Chinese cultural and economic history, ending more than a thousand years ago. The use of capital, not necessarily in the highly intensive form, but the use of capital in this economic cycle we’re talking about was a perfectly normal practice which the Tang Dynasty would have understood easily. They were, by the way, just as inventive as we have been in the last couple of hundred years. What they didn’t have was the ability to go to scale.

Or it could have been as suggested in this Bruegel painting, we could be thinking of Europe in the fifteenth century or the sixteenth century before the capitalist revolution because there was always the reliance on capital. Lower levels of intensivity because there was less capital in total. And it could even have been, we could even be talking about an agricultural cooperative in the Soviet Union, which used capital in the form of tractors and land, and seed, and so on, but used it in a very different way than it is used in market economies.

Chapter 3. Capitalism [00:27:27]

Two: capitalism. Let’s switch now to the lower usage here. It is the use of accumulated wealth to produce more wealth. Marx makes a big point of this wealth, commodity, wealth — WCW — and sees this as pathological, as a distortion of human values. And we’ll talk through Marx in about a week or ten days. The great man — how many of you have read as many as ten pages of Marx’s writing? Where do we read Marx at Yale these days?

Student: Philosophy.

Professor Douglas W. Rae: Philosophy department. Where else?

Student: Sociology.

Professor Douglas W. Rae: Directed studies. What is directed studies read of Marx?

Student: [Inaudible]

Professor Douglas W. Rae: “Communist Manifesto”; that’s great, you’re well prepared for this class because we’re going to read it next week. What would you say of Marx as a writer? First of all he wrote in German, but who’s got an editorial opinion about Marx’s writing? Yes.

Student: I think —

Professor Douglas W. Rae: You’ve got to shout without the mic.

Student: A very talented writer.

Professor Douglas W. Rae: A very talented writer. I agree; a very smart guy. If you were marking a Marx term paper up, what would you find fault with?

Student: A bit long-winded.

Professor Douglas W. Rae: Very windy and a little overwrought, right? He really wants to hit you in the face five times with each thought. But what we’ll discover is interesting is that Marx, in the Manifesto, Marx and Engels, look at capitalism in a way very similar to the way we look at it today. They emphasize its enormous productive capacity and they also emphasize that it is always on the edge of being out of control. Capitalism, as a word, comes into the English language in the middle of the 1800s, and it comes in because of Marx and people like Marx. It is a pejorative used to attack the existing economic system. Capitalism is seen not as a highly productive system but as an unjust system, and it’s criticized in other ways which I’ll tick off in a moment. Anybody recognize this fellow? Yes.

Student: J.P. Morgan.

Professor Douglas W. Rae: It’s J.P. Morgan and does anybody know who took this photograph? That’s a little hard; Steichen. And it’s a very famous photograph. What’s famous about it? What does — what’s striking about this image?

Student: His face.

Professor Douglas W. Rae: Does he look friendly, warm and fuzzy? No, and he wasn’t. I mean this was a very hard edge guy. What seems to be in his left hand?

Student: A chair.

Professor Douglas W. Rae: It is a chair — it is the arm of a chair, but the reflection makes it look like he’s holding a dagger. It was no accident. Steichen was not a fan and this has been used — this photograph’s been used thousands of times in a polemical way. Okay, capitalism as seen in the nineteenth century. A disease for which scientific socialism, that’s Marx’s term for Marx, is the cure. Of course there were twenty or thirty other brands of socialism that Marx regarded as unscientific. It is a method by which to steal the labor from the exploited masses. The reasoning, which we’ll review in ten days time, is that capital can never make money except by using either labor now or the accumulated fruit of labor from the past, and if capital ends up with a profit, that profit must be extracted from either living or fossilized labor. This is not a thought which I share.

It is a system which undermines traditional society in all its forms, and undermines traditional skill sets, and that’s a perfectly true statement. When it happens it is very coercive. It is indeed a trademark of the way capitalism works. That a skill set which was competitive and au courant in 1980 may not command as much as the minimum wage in 2009. This is the kicker for Marx; it is the claim that capitalism inevitably will destroy itself. It will undermine its own foundations and ultimately disappear. We’ll evaluate that view. This slide has cut off the main part of the — of what’s here so I’ll have to remember it for you. Capitalism is the name given to an economic system by its enemies; point one by its enemies. Point two a system which relies heavily on the private use of capital; heavily on the private use of capital combined with the profit motive founded on self interest or family interest. There are hundreds of variations on the capitalist system, but the essentials are private deployment of capital, open acknowledgement of profit as a motive, and a sympathetic understanding of self or household interest.

Another frequent part of the package is a tolerance for innovation. One of the characteristic facts about historical society is a resistance to innovation. And the temptation to resist change is always there. It is absolutely always there and as people grow older they grow more set in their ways and expectations and less tolerant of fresh innovation.

Chapter 4. Course Outline [00:35:16]

This course. We’re going to start with some excerpts from the Wealth Of Nations. It is available on Class V2 posted under resources. How many of you have read at least a chapter of Wealth of Nations? Okay, the rest of you are in for a treat. Smith is not only a great writer but a great thinker. He is a much more complex thinker than we usually imagine him to be. He was not a believer that it’s just fine for the poor to starve in the streets. He actually had very complicated news about that which are broadly analogous to the philosopher John Rawls, and Rawls’ difference principle about what inequalities are justified, namely those which [Inaudible] ultimately in some way to the benefit of the least favored stratum in an economy. The Manifesto, already mentioned, and in both cases we’ll leave out a good bit. Smith is a very old book. I recommend to you the Bantam paperback, $7.95 of Smith because it has wonderful little summaries of each paragraph in italics which allow speed reading, which is actually a very useful thing when a book would take a week to plow through in a careful reading. We’ll focus on just three or four points there, three or four arguments in Smith, but they are really powerful and important readings.

The Constitution of Liberty is by F.A. Hayek and we’ll just read two chapters that will be in a packet, which you will get. Hayek is the arch-conservative, a market conservative from whom most of the conservative movement — not not concerned with social authority — but the libertarian side of American conservatism relies primarily on Hayek, actually. Farewell to Alms, this book, by a guy named Gregory Clarke, is a book which says capitalism: more and better; pour it on. As capitalism increases its reach the world will grow wealthier and better. It is a polemical work, written by an economist, and you will find things to argue with even if you more or less agree with him you will find many things to argue with him about and that will be an important book in the course. The Mystery of Capital by Hernando DeSoto is an argument about why the less developed countries in the world are less developed, and the gist of it is that formal and enforceable property rights are a precondition to capital development. It’s a very powerful piece of work. Richard Posner, The Failure of Capitalism, Posner — anybody know who Posner is? Tell us loud and clear.

Student: A judge.

Professor Douglas W. Rae: He’s a judge and he’s a judge of what persuasion, would you say? He’s a very conservative judge, teaches at The University of Chicago Law School, and he has written a very penetrating analysis of the current crisis. It is — I read maybe 20 books and picked one on this subject, and this is the clearest and most honest, I think, and he doesn’t — he does no ideological distortion here that I can detect. It is just a penetrating and straightforward analysis of what happened, and for that reason very useful. The Bottom Billion by Paul Collier, who is a World Bank economist who teaches at Oxford, and in this maps out a diagnosis and a strategy for using market mechanisms and capital development to alleviate most of the world’s poverty. Finally, The White Tiger, this is fiction, but there are times when fiction is better at describing the real world than nonfiction. This is a brutally penetrating novel written from the point of view of a very poor, very smart, and in many ways flawed young man in South India. It won the Man Booker prize last year for fiction. It is, for our age, it is as good as Dickens and Zola were for the nineteenth century. It’s just a brilliant book. I couldn’t put it down. Ten people told me I had to read it, and I kept shrugging my shoulders and that’s when I started, and I read it front to back in one long day. It is — if you want to understand why there are a billion or two billion people out there for whom capitalism looks not like a powerful mechanism of production but like an extremely coercive system. The White Tiger is a great way to do that. Chris Buckley’s, Thank You For Smoking, is optional.

We will also use the case method and the case method occupies about a third of the course. We will use — the ones in white are straightforward cases, the ones in gold we’ll have the people in the room or some of the people. Polaroid is the story of the land camera and a brilliant technology which ultimately crashed and burned, and it’s — the case is a hard business school case about the attempt to get that business through its crisis at the time that it went broke. Goldman Sachs IPO terrifically — it’s a good HBS case, and better yet we’ll have Paolo Zannoni with us to tell the story from the inside of the Goldman system. Wanda Rapaczynski is the story of getting a business going in Poland just after the death of communism. A Yale-trained business woman who created something called Agora S.A., which is the largest publishing company in East Europe, and how she coped with the toxic environment, the toxic business environment, left over by communism.

Selco India is a microfinance story. Cardiothoracic Systems is a tech story and I’m going to have the Dean of SOM come and do it as a business case with you, which means you’re going to need to wear helmets. She is an aggressive cold caller. By the way, I’m going to make two kinds of calls in this course, cold calls are the kind of thing I did today where you get no warning, and warm calls I’ll send you an email and say heads up about, and in the second case you’ve really got to have something to say. Some of the fun in this stuff is the back and forth between you and me, and you and you. The Enron case, Jim Alexander is an important guy in this course. Jim would you just stand up and wave? Jim was — Jim is a good friend of mine who had a career in investment banking and then at Enron, and he was Chief Financial Officer of Enron, Global Pipeline & Power, and he saw what was happening and got out. He is referred to as the fly in the ointment in Smartest Guys in the Room, which is the popularized story of Enron’s crash. He then went on and co-founded Spinnaker Exploration whose operating principle was: think what Enron would do and do the opposite. Spinnaker became a public company and was extremely successful.

Medley Global Advisors, this is a case about gathering business intelligence and selling it at high prices. Medley is another Yale-trained person. He founded the company and the case is about his attempt to sell the company, which he did, so he’s selling a company that — which is posthumously his, and he actually sold it for fifty seven million bucks, and it’s a no venture medley story and he’s a very interesting guy. Then maybe we’ll talk about Mory’s. I’m chair of a workout committee which is trying to put more effective business and it turns out to be a really interesting hard case. Jim Alexander, Paolo Zannoni, Richard Medley will be practitioner guests. The teaching assistants Leslie Hough, Nancy Hite, Morgan Ramsey, Ramsey-Elliot, and Erlend and me. That’s what the course requires. The course requirements are these, three short memos, one of them can be up to 800 words, and the other two could be up to 1,000 words. Three short memos, a midterm, and a final, and that’s that. I’ll take questions afterward.

[end of transcript]

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