PLSC 270: Capitalism: Success, Crisis, and Reform

Lecture 24

 - Capitalist Enterprise and Clean Water for a Bolivian City


In this final lecture of the semester, Professor Rae gives a summary of major themes, thinkers, and cases covered in the course. He begins by reviewing some foundational ideas, including Adam Smith’s invisible hand, Marxist historicism, Malthusian economics, and Schumpeter’s notion of creative destruction. Professor Rae also reviews the importance to capitalism of the modern nation state, which guarantees property rights and contracts, and recalls Hernando de Soto’s theories about the importance of formal property rights for developing countries. Various forms of corporate structure and ownership are discussed. Professor Rae concludes by introducing a case about water privatization in Bolivia.

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Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 24 - Capitalist Enterprise and Clean Water for a Bolivian City

Chapter 1. Introduction, Class Agenda and Fundamentals Revisited [00:00:00]

Professor Douglas W. Rae: Okay so the object today is to wrap our arms around, not all but a good portion, of the material covered. The book called, Bottom Billion, is somewhat neglected in today’s discussion but should not be neglected in your essays. Indeed, your essays will need to take account of many of the things said by Paul Collier in that book. First of all, our topic slide here, you have to ask yourself first what this guy believes that umbrella is going to do for him. It’s — and I’ll show you the subsequent slide in the appropriate place about what happens next, but the gist of that slide is that capitalism is a dynamic system which is always leaning forward and is always within a few months of leaning too far forward. It is the nature of the system.

Okay I’m going to begin by revisiting the fundamentals, these systems of ideas that we began the term with, and then we’ll look at some of those system in greater detail. Thomas Malthus, Essay on Population, the thesis is that nearly universal poverty is inevitable, because wherever productivity increases, population increases apace, and the resources used for production have diminishing returns as you invest more and more labor. Malthus is obviously thinking about farming, and farming in a small island called England, and he’s wrong. The world demographic transition utterly contradicts his theory, and the fact that birth rates and death rates might fall in the precipitous way they did is the world demographic transition and is a major key to why the world economy works the way it does, because it produces an enormous surplus of labor in the societies which pass through it later rather than earlier.

Similarly, if we look at Hans Rosling’s wonderful data animation which we used on the first day of class relating life expectancy to GDP per capita, the world in the last 120 years has grown richer on average five or six fold, 500% or 600%, richer and healthier, longer lived so that there is a human project, a world human project in which the best of capitalism participates, and I think that’s the important upside to the topic. Adam Smith, “invisible hand,” and Smith has become in death a more famous figure than he was in life, and a simpler figure. The number of people who have actually read Wealth of Nations or read it and Theory of Moral Sentiment is a tiny fraction of the people who claim to organize all their thinking around Adam Smith, and Adam Smith’s invisible hand is a fragile thing which operates not with giant corporations, not with oligopolies, not with monopsonies, it operates under conditions of perfect or near perfect competition. And the Porter Forces which we have seen, direct competition, the threat of new competition, the threat of people moving to substitute products, the power of suppliers and the power of buyers to bargain, all five of those factors work against the invisible hand. The whole point of the Porter Forces is how business corporations avoid being compelled to behave in the Smithian way of producing goods and selling them at or near their marginal cost.

Carl Marx and Joseph Schumpeter; two great economists, two great thinkers, Marx the founder of a revolutionary movement, Schumpeter a banker, a Harvard professor, a brilliant intellect; two ways of looking at the same thing. What these two guys agree on is that capitalism is an inherently unstable forward-moving system. That the one thing of which capitalism is incapable is standing still, that like the bicyclist in my title slide, capitalism always leans forward and always relies on events in the future which are not predictable. Now where the two part ways is that Marx is a determinist; Marx really thinks that he can foretell the history of capitalism in its main outlines. And he was mistaken; of that we can be sure. Schumpeter, on the other hand, believed that the future of capitalism is inherently indeterminate. That there is much random process, so much opportunity for unexpected innovation, that the prediction of capital — the behavior of capitalist economies, beyond the very short term, is impossible, and I’m inclined to believe that Schumpeter’s right about that.

Hayek. Hayek is the guy who wrote Constitution of Liberty, and it’s possible to be very critical of Hayek, who does play some logical tricks with his reader. On the other hand, he puts forward a passionate vision about the creative possibilities of a free society. A society in which the right to innovate the right to choose, the right to author ones own life and propose scripts for the lives of others; a society which is open and not subject to overbearing hierarchy and bureaucracy is a learning machine, and Hayek is a brilliant theorist of that learning machine. Another set of fundamentals, this is Ronald Coase, he of Coase theorem fame. This is Hernando de Soto, he of Mystery of Capitalism fame, and what they both say is that capital formation relies on governments and courts, and the formalization of property rights, and that one of the foundational aspects of our wealth in the western world is tradable property rights so that our houses are also small storehouses of capital, and our earning power can be the collateral for debt which is repaid through future earnings. That whole aspect of capitalism, that whole metabolic process is at the fundaments of the best aspects of capitalism, the aspects that involve sustained prosperity.

Okay with the remaining forty minutes of our class, I’m going to go through these topics, you can just take a quick glance at them. They are basically the details of what I’ve just adumbrated, and the last of them is the case for your final.

Chapter 2. Capital & Capitalism [00:09:33]

Okay capital, capital is accumulated wealth reproductively deployed. It can take the form of cultivated land, it can take the form of seed corn, it can take the form of factory machinery, it can take the form of stock certificates, it can take the form of educated people; indeed, in a very real sense you are in the process of capital formation during your years as university students. You will be an embodiment of capital, and indeed, capital of a high order when you finish Yale College or the School of Management, or the law school, or whatever may be your last stop.

Capitalism, on the other hand, is the name that socialists gave to a whole bunch of things they didn’t like. Private businesses that, in their view, exploited labor, in their view despoiled the environment, in their view desanctified historical and religious tradition, and there is no inventor of capitalism. Adam Smith didn’t use the term, Adam Smith didn’t even like joint stock corporations; he thought they generally didn’t work well, but it is an organic system, which develops over time, and as Hayek and Schumpeter and others point out to us, is capable of self-modification through time.

Marx’s historicist theory of this, and we did a whole lecture on this in September, with the idea that capitalism always turns toward monopolies that capital becomes too abundant, and the rate of return on it falls with time, that the working class is eventually starved out, eviscerated to use the term, the inevitable revolution in advanced capitalist systems. The places the revolution occurred were always in the least advanced market societies, places like the Soviet Union. The theory of a universal class, that once the working class captures society there will be no class below it, and therefore, no possibility of conflict and exploitation, the withering away of the state. Well here are the places where the revolution occurred in red, and it occurred in almost all of them because the capitalist order was not developing and not maturing, rather than that it was developing and had exhausted itself. The withering away of the state takes awhile.

This is from the Communist Manifesto, and this is where he gets it right. The notion that the bourgeoisie, that is capitalists, cannot exist without constitution — constantly revolutionizing the process of production, that the conservation of old ways of doing things was characteristic of every previous economic system but not of capitalism. “All that is solid melts into air. So the flat part of this is pre-capitalism, this is the Angus-Madison Curve that Clark in his Farewell to Alms uses as his thesis again, and again, and again. And the upturn corresponds to the capitalist era. Now it also corresponds to the era of intensive use of fossil fuels. It also corresponds to the era of radical urbanization, and it also corresponds to a period of extraordinarily fast technological innovation, and you can say that I give capitalism too much credit, and I’ll settle for agreeing with that. But I will also say that capitalism is a — has within it, endogenously, enormous incentives for continuous technological innovation and for the rapid deployment of desirable technologies, and in that way it differs from all other systems.

Capitalism during its rule of scarce 100 years has created more massive and more colossal productive forces than have all preceding generations together. That’s a true statement. It was made in the winter of 1847-1848 and it was arguably true then, it is vastly more obviously true today. That in roughly ten generations, maybe twelve generations, capitalism has created more total wealth and total spending power than all the economic systems which occupied human history before that time. Now Gapminder, I’m actually in a little bit of a — I don’t really have time for a Gapminder exercise, but there it is,, just go and play it. Play it for yourselves if you want to be sure that we’re not talking about something imaginary.

Now what an interesting exercise to do is to single out some command economies such as the Soviet Union before it — in 1989, or Cuba throughout the last sixty years and watch them, and what you’ll find is they do relatively well on the health and longevity dimension and not so well on the GDP dimension. It is perfectly reasonable for someone to say, “I don’t care about wealth. I care about health and good spirit and all that, and I’m not interested in being part of a society that generates enormous wealth,” and there are very reasonable and rational people who take that view. It’s an option and its fine, it’s even admirable, but it’s not what capitalist market societies are about.

One reasonable critique of capitalist market societies is that they encourage us all to consume way beyond our real needs. That we spend more money on clothing and automobiles and sporting equipment, and liquor than is really needed, and there’s no doubt of that. I’m guilty myself, and my guess is that most of you feel the pull of market society and the inclination to spend more than would be absolutely rational or necessary. Fair enough; it’s a critique, and I think it’s a valid one.

Chapter 3. State, Property, and Capital [00:17:38]

The state, property, and capital; back to Smith. Smith famously talked about the night watchmen’s fate, the state which focuses primarily on law and order, and the enforcement of contract; the state which makes it possible for a person to own property, to deploy that property productively, and to make money by satisfying the apparent needs of others. Now in order to have a night watchmen state you better have a state, and Smith wrote roughly two centuries, a century and a half, after the Treaty of Westphalia 1648, which was the launch point of the modern nation’s state system with a monopoly on force and violence, and Smith is in a sense building a theoretical system on the foundation of state-enforced property rights. In fact, not just in a way, that is what he does. These are the states involved in that treaty.

This is Thomas Hobbs whose Leviathan is the defining tract on nation states, and which defines the leviathan as a monopolist on force and violence. We prevent being the victims of one another by entrusting to the state a full monopoly on the use of force and violence, and in that way, profit enormously through peace, security, and the ability to plan ahead based on our current property holdings. The nation state system lays out like this. It is in many ways, I think you can say this definitively, capitalism without the nation’s state system is infeasible. That if there were not the coercive agency of the state in the background to vouch safe property and contract, to perform the functions de Soto attributes to it, if it were not for that, then none of the capital formation processes that are vital to our wealth would be reliable and feasible.

Now you could invent some entirely different system. You could invent a system which sliced the world on another angle, conceivably a functional angle, or could be a gender organization in the world. There could be a state for women and a state for men, the geography of it would be a little tangled but they’re going to reproduce, but the gist of this is that capitalist wealth rests on the foundation of the nation state system and the nation state system is not altogether a pretty story. Here’s the British Empire as it stood in 1920, or the 1920s, and none of these places shown in red volunteered to join the British Empire. Now you might claim that Australia and New Zealand did, I think, but even that’s a reach. The British Empire was an extremely coercive device for occupying territories and extracting from their economies a vast surplus for the metropolitan country. It had many knock on effects which worked out well. The — much of the infrastructure and educational systems which makes India so promising today is partly related to the best parts of British raj, but the colonial background is a part of the nation state story.

The function of states having no state versus a state, having a failed state versus an effective state, having a state which fails to promote formal property versus one that does, the one point in the tree which leads to the existence of what de Soto calls live capital is this one, and lucky for you and me, it is the one which envelops our lives in the United States and in the western world. The — and de Soto’s thesis really boils down to this two-by-two table with dead versus live capital, and formal versus informal property rights, but in the back of this is the notion that you have to have a state which effectively and efficiently administers property. And that means an elaborate court system, a vast number of lawyers, barristers, and the like, a huge recordkeeping system, and a — and behind it all a government capable of enforcing property rights against theft and expropriation.

This map of this neighborhood of New Haven, the green lines are the property lines, and the vault at 200 Orange Street contains the records corresponding to each of the green polygons, and in the city there are 26,000 and some green polygons like that, and the whole surface of North America is covered with analogous polygons which are seed points of capital formation, and energize the economy. Now de Soto constructs a strategy of conversion from dead capital to live, toward the back part of the book with these phases indicated, and in many parts of the world, in much of Latin America, much of Africa, some parts of Asia, the campaign to create live capital is a very real and live campaign today, and is strategically of considerable importance.

As you think ahead to the case you’re going to write about, in Cochabamba, Bolivia, and about which we’ll have a few minutes to talk toward the end of this class, the very informality of that economy is part of what kills Bechtel and its development projects. De Soto makes quite a lot of how it is that you can’t have an informal system of property and then just impose, cookie cutter style, a formal system of property which no one understands, and which doesn’t correspond to their beliefs. You’ve got to adapt the formal system to the informal system, and if de Soto is right and I think he is, part of the brilliance of American property law was that it found ways to incorporate again, and again, and again to incorporate informal property rights like the Tomahawk farm, or the miners’ rights recorded in miners’ association records having no relationship to government. Government didn’t come along and say, “No that’s all baloney, we’re going to do it our way,” government came along and said, “Oh we see, now let’s put that into language which can be incorporated in the law, and which can allow the law to work with rather than against the property rights which you have established among yourselves.

Ron Coase, Coase is a Chicago School economist and a — and he’s written — he wrote all kinds of wonderful scholarship, and what’s called the Coase Theorem is really post hoc reinterpretation of his work. He never sat down to write a paper called “my theorem,” and the insight in it is really pretty straightforward, and I make it a little simpler than he would like it. But as we said before, where there are clear initial entitlements, where the entitlements and the opportunity to change them are transparent, and where the information is shared in a way that is relatively symmetrical so that we don’t have situations where a buyer or a broker knows all kinds of things which a customer doesn’t know — I said that wrong — where an owner or a broker knows all kinds of things which a customer doesn’t know; and finally, low transaction costs. A practical story; have any of you ever been involved in a buying a house or being part of a family as it bought a house? Yes. Okay, that’s informative. Did you — what did you do to remedy the information asymmetry between you and the seller?

Student: I didn’t do anything.

Professor Douglas W. Rae: You didn’t do anything, but what did your family do?

Student: Visited the house.

Professor Douglas W. Rae: Okay and just that?

Student: I’m sure they had all sorts of papers but —

Professor Douglas W. Rae: I hope what they did was hired someone to inspect the house and give them a report. Let’s check with the gentle — behind you. Do you have experience with this?

Student: Yes.

Professor Douglas W. Rae: And —

Student: We had it appraised.

Professor Douglas W. Rae: Okay you had an appraisal.

Student: Yeah.

Professor Douglas W. Rae: And did you have anybody look at the pipes, and the roof, and the — and all that?

Student: Yeah.

Professor Douglas W. Rae: Good I’m glad. The — there’s a — I say this because I, four or five years ago bought a house with a slate roof and I got a report which called the condition of the slate roof “very good.” Well it turns out that “very good” for a slate roof costs about $20,000 a year in repairs, so it was a very bad decision on my part, but the information symmetry part of this is central and the idea is that you can get efficient market, including an efficient formation of capital through leveraging real property where those conditions are met. So as a practical guide in doing things you get three things to tick on your fingers and think about in managing the affairs of an organization or a firm.

This is too complicated; the rough idea here is to take the three factors in Coase and run them against the obvious aspects of the nation state system and look how — take an example technology transfer relates to transparency so that where one segment of society has unique access to technology and knowledge that others lack, you can assume there will be huge asymmetries in the distribution of information and that that will distort the functioning of the economy, and sure enough it does, and part of the justification for government provision of public education is that it provides the minimum access to information and the methods of obtaining information which are required by citizenship in a democratic and market society.

With any market economy you’re going to expect to move northeast of the status quo. I did an elaborate exercise with Edgeworth boxes with you about a month ago, and where you start determines where you end. So if we start here, where the Smith’s have almost everything, we’re going to end up somewhere up there. Or here where the Joneses own almost everything, we’re going to end up somewhere here. So what Coase doesn’t say is that there is some particular symmetry or justice to the way property rights move, and indeed, it’s worth stopping to say that to ourselves. Whomsoever expects social justice from a market economy expects in vain.

That’s not what market economies are good at, they’re good at a lot of things, but you cannot when you are a wealthy septuagenarian, and I’m at least one of those two, you cannot say to yourself that it is the just verdict that the American economy that I should be well to do. It has in it all kinds of happenstance factors, including the luck of one’s birth, and the generosity of one’s educators that those things happen, and so the claim I — people, I am clearly pro-capitalist, but when I argue with people and they say, “Well you know there are all kinds of people who have more money than they deserve and others who have less,” I say, “Yes, I agree, and there may be other remedies you want to take for that.” For example, giving some people some of your own money, but the claim for capitalism just doesn’t go there.

Chapter 4. Wealth Maximizing Law & the Joint Stock Corporation [00:32:56]

Wealth maximizing law and the joint stock corporation; the law that government creates can either be well designed or poorly designed to create wealth, and we started some months ago with Ghen v. Rich, the matter of a sinking whale and the tailoring of the judgment in that case to preserve the incentive for the whaling industry, by allowing the principle gains to go to those who take the largest risks and make the largest investment and that’s the intuition of wealth maximizing law. Another case we I think looked at, I’m not quite sure, did we do U.S. v. Cosby, the one about air rights? Well you get it. Before the airplane it was perfectly sensible to say that the air rights over one’s land extended to the end of the universe, or at least until they got to the next inhabited solar system. That was a perfectly okay thing to say and did no harm, but once air travel became part of the technology, it had to change that precept and grant the right of free trespass above a certain altitude. This is Marc Lanier; did I show you guys a little bit of Marc Lanier? Okay and the dark side of wealth max — the top side of wealth maximizing law is tort law and the lawsuit. But the thinking behind having lawsuits is that lawsuits provide an incentive against carelessness in dealing with the lives of others and the punishment that a company gets for producing a hazardous product or performing a risky and failed medical procedure is a way of keeping manufacturers and healthcare people honest and careful.

The critical features of the joint stock corporation, as compared with straightforward proprietorship and partnership, are first of all that the chain of accountability is thin. That is the customer’s and investors; both have only a thin relationship with the decision makers in the firm. If you owned 1,000 shares of General Motors and you think they shouldn’t have fired Fritz yesterday, as they did, you’re going to waste your money by calling them up to talk about it. If you’re the owner of a General Motors car and you don’t like the way the door handles are put on, it’s not much use calling them up and asking them to do it differently. What you have to do is buy another manufacturer’s car. The role of ownership is passive. The investors buy shares and if they don’t like the course of the company’s management they sell the shares.

Liability is limited; the most that an investor can lose is what she put into the shares that she purchased, and that’s a great provision right. If you’re an investor it means that you really don’t have to do much homework, at least homework about the downside of management practices. Liquidity is like water. It is a perfectly liquid instrument and it is an endlessly scalable instrument, and the joint stock corporation is about — between 88% to 90% of a market economy is embodied in joint stock corporations. Whenever there are flaws, and their flaws are many, Jim Alexander here has told you of a few, their flaws are many but the ability to produce at enormous scale, with enormous efficiency, is very real. I’ll post these slides so you don’t need to write down all my squiggles. But the most important feature is that you’ve got centralized management which has a thin relationship both with customers and with investors and is — and has the capacity to engage in efficient production of stuff people actually want to buy.

Vertical integration is a key feature of companies like this, vertical integration meaning that the company engages itself in a long chain of activities which start, in the extreme case, start with raw materials. For example, iron ore in the ground, tobacco growing in the field, lobsters crawling about under Penobscot Bay and finishes with lobsters on the plate, with a completed automobile or whatever, and vertical integration creates an enormously difficult management challenge, and often companies wisely walk away from some aspect of it. The car companies, for example, have been shedding the manufacture of many of their intermediate parts now for thirty or forty years because it was so difficult to manage. But the advantage is that it gives the company enormous autonomy from others who seek to intervene in its operations.

The vertically integrated corporation is also, from a public perception point of view, quite often a monster. Alex, I think it was, referred us to the picture of a vampire squid for Goldman Sachs and that picture actually goes back — this is an 1881 cartoon of Standard Oil pictured not as a vampire squid but as a giant squid with tentacles reaching into everyone’s living room and it was that. Vertical integration from an olive grove to Palmolive Soap, that’s the gist of this. The slogan on the Palmolive Soap, “I learned from a beauty expert how to hold my husband.” That’s a terrible way to sell people soap. That is just wrong. It just is. But marketing does that and it’s part of the package in a capitalist market society.

The first great corporations were the American railroads, or at least in American history, and the Alfred Chandler piece about the Pennsylvania railroad is a good example of this. They involve enormously large scale investment of capital in the railroad infrastructure in rolling stock, and they created a challenge to management which no previous business had created. So you’ve got 50,000 employees, and you’ve got these enormous contraptions running at one another all over the place, and incidentally, in the early years killing 5,000 or 10,000 people a year and the management of all that required one of the great revolutions, which I have spent little time on in this course, where in the joint stock corporation, you’ve developed a huge cadre of professionally trained managers, like the crowd sitting back right, soon to be freshly minted Yale MBA’s who are going to run — I don’t think they’re going to run trains, but they’re going to run big, complicated things.

Goldman Sachs is a different kettle of fish. Goldman Sachs is not vertically integrated at all. It occupies a strategic position in the economy which allows it, economy and government, which allows it to create — to use enormous leverage and enormously high powered expertise to generate revenues on a more or less unprecedented scale, and Paolo Zanonni is my very dear friend. He really is, I mean we’re really good friends, but I would say — I would say it to his face. I probably wouldn’t say it in front of 100 people to his face, but I would say it to his face that he earns way too much money, just outrageous how much money he earns. Now I wouldn’t invent a law to take his money away but I do think that there’s more of it than he needs or deserves, but like I said capitalism doesn’t solve that problem.

This is the inner courtyard at Infosys in Bangalore, in India, and the process of very rapid formation of gigantic wealth in — through the best joint stock corporations is a worldwide event and the world would be a better place if there were more of it. The Ibbotson slides which I showed you some months ago, for the U.S., summarized what becomes of a dollar invested in 1927 as common stock and that kind of growth is characteristic only of very well managed equity investments.

Chapter 5. Creative Possibilities of a Free Society [00:43:33]

Greater possibilities with free society; Hayek conceives a society as a learning machine, and the score of knowledge and institutional practices which are built up in a market society, build up in an exponential way like the green curve here, and the most important fact about that is that no individual knows a very high fraction of the total knowledge of the system. We are all — we all need to be self consciously humble about how little it is we know about the total operation of the system. We are all looking at 1%, 3%, 2% of the data which make our society function or fail to do so. That condition, it’s more and more obvious, right? If you think about what it is that is on the screen in your — on your study desk, what’s accessible on that screen at any given moment is thousands of times more than you will ever command.

Chapter 6. Case Discussion: Bechtel in Cochabamba [00:44:52]

I’m going to have to stop there with that and go back and go to the case, because I want to have time for that, and I’ll post — I’ve got three or for more topics there but I’ll post the slides and I want to discuss the case with you. Of — can we turn this — how many of you were able to look at the Finnegan piece so far? Got your attention, good; you ought to start by — I would start interpreting this story by asking yourself about Bolivia’s history in social composition and where it fits in the world economy. How it relates to Paul Collier’s Bottom Billion and here’s one obvious way it relates. Collier has a series of what he calls traps, if you run Bolivia through all the traps you will see that it is not a favored nation. It is a nation which has many vulnerabilities, and it is consequently on the lower edge of the world economy.

Now, it has a city called Cochabamba, about 800,000 people with a water company called — a water agency called Siempas and that agency is terrible. It does a very poor job of delivering water. It is also corrupt and a very high fraction of the water distributed is distributed illegally, people tap into it, just as in poor countries people tap into the power cables that run through their areas. The — there are two gigantic agencies, The World Bank and The International Monetary Fund, which believe in markets in a big way, and they have pressured Bolivia and fifty or seventy-five similar bottom billion countries to marketize their economies through private investment. And the gist of the story is that the investment of private capital will incentivize companies, typically well financed joint stock corporations, to do an awful lot better job of providing water, electricity, rail service, air service, all the basic functions of an economy will be better performed privately than the were publicly. The people who are — the inspirers of that are called The Chicago Boys, a group of young economists, the most famous of whom is Jeffrey Sachs, who was then at Chicago but is now at Columbia, and the market tonic is what was applied in this case.

Now the case didn’t work, the tonic didn’t work and one conclusion is that market reform is altogether wrong and will fail everywhere. I think you can gather some evidence through your reading and through Collier one way or the other on that point. The gist of the question, which I’ll post tomorrow, is explain what happened when Bechtel, through its wholly owned subsidiary, went into Cochabamba to re-conceive, reconfigure, and reconstruct the water system. Interpret that story in light of the most important things you’ve learned in this course. Are there questions? Okay we’ll see each other again on December 14, at the exam.

[end of transcript]

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