Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 4 - Karl Marx, Joseph Schumpeter, and an Economic System Incapable of Coming to Rest

Chapter 1. Introduction [00:00:00]

Professor Douglas W. Rae: Okay, let’s go to work. Violating the syllabus, I’ve re-titled today’s discussion “From Marxist Historicism to Howard Head’s Tennis Racquet,” and let’s begin with Howard Head’s tennis racquet. Howard Head was an alum of Harvard College, a bright guy, and a not very good airframe engineer. He was a second-class designer of the details of airplanes for McDonnell Douglas Corporation, and he was an avid skier, and an avid, but very untalented, tennis player. As he tells the story, there was a night on a bus, a motor coach to use his words, bringing him back to New York from Vermont, from Stowe, and he’d had a rough weekend of skiing and he said, “What would happen if we took the aluminum wafer with which we’re building airplanes, and made a ski from it?” Sure enough he did that, and the skiing industry, not just the sale of skis but the total size of the skiing market, was transformed forever because skiing now became more fun and vastly easier. Five years later he had the same — he applied the same thought process to tennis racquets.

At the time the world market in tennis racquets had converged on the Bancroft wooden racquet, named for Jack Kramer, who died — his obit is in The Times this morning — and everybody was competing on price and details of quality with the wooden racquet. There were no rules about how big a racquet could be. It occurred to Head that, if he substituted in the bow of the racquet, substituted aluminum for wood, the structural properties of aluminum would allow the head of the racquet to be much bigger. Do any of you play with giant tennis racquets? I know it’s a point of pride among really good players not to do that. Mine — I retired from tennis three or four years — mine at my retirement was about like that. It makes tennis easy, and it created a mass market and it redefined the whole business.

Now the idea of creative destruction, which is usually about things more complicated than skiing and tennis; the whole idea of creative destruction is that the process of competing to sell the best product at the lowest price within the given market framework often does, indeed, lead to something like monopoly, or at least oligopoly, and a point made at length by Marxist critics of capitalism. As that happens, it occurs over and over and over again, that somebody like Howard Head finds an alternative technology invariably aimed not at luxury markets, aimed at regular people, and very seldom aimed at corporate or governmental buyers, but again at private sector buyers, and generates with that product an entirely new market, shatters the equilibrium, hits it with a hammer. And this thought is, on the one hand, antagonistic to Marx. That is, it is a way of refuting Marx’s idea about monopoly capitalism.

On the other hand, it is exactly in the spirit of young Marx, the young Marx we hear in The Communist Manifesto read for today’s assignment, who saw capitalism as an enormously productive system which was incapable of standing still, which was always leaning forward into the wind, which was, to use Schumpeter’s term, nothing more than a mechanism for economic change. According to Schumpeter the very essence of capitalism is that it is a system always in the process of revising itself. It is never capable of standing still, and young Marx certainly believed just about that same thing, and believed that the productive forces — now remember he’s writing in 1847, 1848 — that the productive forces associated with capitalism were unprecedented in world history. May I call on one of your classmates to read the pivotal paragraph from that work?

Student: “The bourgeoisie cannot exist without constantly revolutionizing the instruments of production, and thereby the relations of production, and with them the whole relations of society. Conservation of the old modes of production in unaltered form was, on the contrary, the first condition of existence for all earlier industrial classes. Constant revolutionizing of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation, distinguishes the bourgeois epoch from all earlier ones. All fixed, fast-frozen relations, with their train of ancient and venerable prejudices and opinions, are swept away. All new-formed ones become antiquated before they can ossify. All that is solid melts into air; all that is holy, is profaned; and man is at last compelled to face, in sober sense, the real conditions of life, and his relations with his kind.”

Chapter 2. Marxist Historicism [00:06:30]

Professor Douglas W. Rae: Thank you very much. Marx is there talking about the — at the time he’s writing, railroads are just beginning to transform the European world around him. Steamships are a generation and a half into transforming world commerce. The use of newly efficient steam engines in manufacturing is creating ever cheaper goods. The market in world textiles has driven the price of ordinary cotton cloth nearly to zero, so that nearly everyone in the market — advanced market societies, can afford to dress, more or less, the way all of you are dressed. That is to say, whatever, look around. But the point is that the revolutionary transformation of the means of production, and of what is produced and at what cost it sells, is very much on Marx’s mind.

Additionally, Europe is politically unstable in the 1840s. And there are five or six nodes of apparent revolutionary activity stretching from Austria through Germany, into tsarist Russia. And Marx imagines that his relatively abstract analysis of capitalism is scientific. By scientific he means that it has predictive force. That his science of economy and society is so powerful that it allows him to foresee the future. Not to foresee the exact dates and details of future history, but that the broad outlines are beyond human control. There are actually two assertions here. One is that the world’s history is determinate, that it is like the machinery of the heavens, it is like the planets revolving around the sun. A good astronomer can readily predict the phases of the moon, the occurrence of eclipses, all those things, and that’s science which was in the past by Marx’s time, and which he aspired to that level of confidence.

We’re going to look at his historicism, that is, the double belief that the world is deterministic and that he and his associates can actually unlock the keys to the future, under six headings. The first of which is monopoly capitalism, and we’ll take that up momentarily. Second is the proposition that, in the long run, the rate of profit for capitalist enterprises has to fall. Third the immiseration of the working class, that as profits fall, so does the wage stream available to the working class. So both the capitalists and their adversaries in the proletariat face a squeezing vice which takes their discretionary power out of the system. As the vice squeezes, revolution becomes inevitable. That’s the fourth point on the — or the third point on the chart. The fourth point is Marx’s — I’m a great respecter of Marx’s brilliance, but the theory of the universal class is almost childlike. The idea is that if you search out the bottom of the bottom of the bottom classes than that class will have the unique property that it has no one else to exploit. If it has no one else to exploit then there won’t be exploitation, and since the purpose of the state is to defend the interest of an exploiting class, then the state will become unnecessary and will, as the bottom line says here, wither away. Now the many decades of experience we have lead us to be friendly critics toward the top of this story and unfriendly critics toward the bottom because the story told at the bottom is not only false, but dangerous.

Chapter 3. Monopoly Capitalism [00:11:36]

Monopoly capitalism — you’ll remember that when I was sitting with Jim Alexander last class talking about Adam Smith and the conditions under which the invisible hand remains invisible, I used the Porter Forces commonly used in MBA instruction to define the opposite of each of the conditions put forward by Smith, and so I’m using them again here. In a monopoly capitalist situation, the monopolistic firm has eliminated direct competition or rendered it trivial. It has caused the erection of high barriers to entry so that as its profits increase and others say, “What a good idea let’s get into that business,” it has ways of keeping them out. Or, once they come in, of punishing them to the point of bankruptcy.

Third, these are products that are not discretionary; they’re hard to substitute for. You can’t have a serious monopoly in children’s games. You can’t have a serious monopoly in a given fragrance of aftershave lotion or of perfume. Serious monopolies are always in things which people need and for which they don’t readily find substitutes. The firm is vertically integrated, and by vertical integration I mean, think about starting — well, let’s take the laptop in front of you. Starting with the aluminum, the silica, the metal wires, all that stuff; starting with raw materials that are in the earth, extracting those, designing them, fabricating them, marketing the machine, distributing the machine, that whole long trail of production from raw materials at the one end to finished product in the hands of a buyer at the other. Vertical integration, in the extreme, means that the corporation controls that whole sweep. The part that reaches from manufacturing toward the buyer is called “forward integration.” The part that reaches from the manufacturer back to raw materials is called “backward integration.” This pattern of integration gives the company great power because there are no suppliers who can hold up the firm for a part of its profits. Buyers don’t have leverage to control prices. Competitors can’t manufacture a very similar machine 20% cheaper and drive down profits. And people in substitute industries don’t have any way of drawing away customers.

That’s the — I’m caricaturing — but things which more or less fit that description historically would be, for example, Standard Oil. John D. Rockefeller who controlled — who came into control of oil all the way from exploration and the wellhead. Through refining and distribution, he came to control the railroads, which his rivals would need to use to distribute their product, and managed to use the railroads to impose artificially high freight prices on his competitors so that he was able, in effect, to monopolize the whole industry. The — U.S. Steel, a similar story. This would be Andrew Carnegie. Microsoft. There has been a long debate about antitrust for Microsoft, and it’s pretty close to a monopoly. I look around the room and I see little white Apples illuminated everywhere, and I have one myself. My eldest daughter is a partner-level executive at Microsoft and in her house are Apple computers, which I have given her family.

Another story of the same instance is the regulated airlines. The regulated airlines, this is before the late 1970s when the airlines were deregulated, would own a route and monopolize it. And they would compete not on the basis of price, because they would charge monopoly prices. They would compete on the basis of food and attractive flight attendants — and I’m not going near that. The big pharmaceuticals, or pharmas, are sometimes in monopolistic or near monopolistic positions about drugs and many other cases, though fewer than the ideological critics of capitalism would make you believe, and fewer partly because of creative destruction. As monopolies ossify people find ways to blow them up.

Let’s talk about that. On the left side of this little diagram we have ways to build a monopoly, and on the right side, ways to burn a monopoly. And on the vertical we have market forces and on the horizontal, the top horizontal, we have market forces. The bottom horizontal we have governmental forces, and let’s just get ourselves familiar with the four resulting cells. Scale and scope, mostly scale; if there are returns to scale so that each widget gets cheaper to produce as you produce many of them, the firm which is producing the largest quantities enjoys an enormous strategic advantage. Illustrated here, if number of widgets produced is on the horizontal dimension and the marginal cost of the last widget is vertical, being positioned where this little green company is positioned is an enormous advantage in comparison with the little orange firms at the left. These are boutique firms doing very little, and the giant producer, which in the American economy for a very long time was General Motors, for example. It’s General Motors and its immediate competitors in Ford and Chrysler. Let’s — I’ll illustrate the point. At the time of — the decade before World War I there were 1,200 automobile manufacturing companies in the United States, and almost all of them got winkled out by the end of the 1920s. There were about a dozen at the end of the 1920s. We’re now approaching — what number are we going to end up with?

Student: Zero.

Professor Douglas W. Rae: Zero is one real possibility. More likely, I think one, one and a half, two, something like that. But the scale economies in that kind of business are enormously important. Creative destruction, and here we have Schumpeter again, and one way of using Schumpeter is to take a very long view of dominant technologies for energy and production, and look at how they have shifted over time. In this chart — is that legible for any of you or not? Not really? Okay. The chart begins with production based on water power; on mills based on falling water. It turns out historically that these were very important. The first great advances in the manufacture of textiles occurred in plants located along the fault line of rivers, where it was possible to extract a great deal of energy from falling water and drive mass manufacturing.

Then you have creative destruction with the emergence of steam and rail as alternatives. Then electricity, and I won’t pause long but the great battle of the 1890s was between alternating current electricity, controlled by George Westinghouse, and direct current electricity controlled by Thomas Edison, both of them as corporate leaders. Yale didn’t fully give up on direct current technology until about 1985. There were dorm rooms were the lights were actually run on direct current generated in a plant over near where the swing dorms are now. I’ll leave it to sections for you to parse this out because it’s actually a very interesting story. The advantage of direct current electricity is it can’t kill you. It doesn’t matter how much, it’s not going to kill you. The disadvantage of direct current electricity is that as you put it through a long transmission wire, you lose most of it after the first five miles. So Edison controlled direct current electricity, and wanted to make the government regulate it in. So what did he do? He stressed safety. And so if Edison had won, there would have been a generating plant about every five miles all over the country, in every urban neighborhood its own generating plant. How did he dramatize that? Yes.

Student: The electric chair.

Professor Douglas W. Rae: The electric chair, exactly. He put forward the view that, well Westinghouse has a great technology if you want to kill people, and actually did demonstrations on animals and all that sort of thing, it was just awful. Ultimately it was a case where the unregulated market won. The government stayed out of it, and alternating current, from the point of view of illuminating our classroom, is pretty efficient. Then you get petrochemicals and digital networks — this is all very stylized in this diagram — but the point is that monopolies, one after another, after another, after another get winkled out by these changes in the underlying technology. New Haven at one time was arguably the leading manufacturing city for horse drawn carriages. Well, it was over, and over pretty suddenly.

Regulatory capture. Regulatory capture means what it says, and there’s a basic political science kind of a thesis about this, which is that regulatory agencies get captured by the companies they regulate. If I’m a bank or a brokerage, I’m intensely interested in the SEC and I develop friendly relations with it. I feed information to its staff, its staff comes to rely on me. After spending a cycle of four or eight years in a politically appointed position in the regulatory agency, it occurs to people that they might pursue a career in the industry they’ve been regulating. There gets to be a reciprocal relationship there, which allows a dominant firm to enjoy some advantage from its relationship with the regulator. The current crisis in banking is a little different from this and it’s not really monopolistic, but it is not unfair to suppose that Goldman Sachs has enjoyed a fruitful relationship to the Federal government in the last four or five decades, and that there have been very few times when there wasn’t a Goldman Sachs partner in a position to influence key decisions.

The more classic story would be the airlines, the one I told you where TWA, Pan Am, and all the others of that era had this monopolistic relationship created by airline regulation. What killed them was that enjoying a monopoly relationship to the airline regulators allowed them to be pretty soft. They didn’t have to control costs; they could waste $.15 of every dollar in profits and still look great to their investors. When deregulation came the “legacy” costs were lethal to many of these firms because they were up against, now, they were up against airlines like Southwest which had no legacy costs and ran very efficiently.

Finally, antitrust. Antitrust emerges in the states with the Sherman Antitrust Act of 1890 and is — there is a continuous oscillation in government policy here and in most other market economies, between strict and not so strict interpretation of what counts as a monopoly, and what counts as predatory monopolistic behavior. When we get to cases we will see several specific instances of this.

Chapter 4. Falling Rates of Profit [00:27:31]

Falling rate of profit. Remember those of you who were here the first class, the slides that contrasted labor intensive production, and for example, I had two yaks pulling a plow in Tibet juxtaposed to a twenty-ton John Deere tractor tilling earth in Minnesota, Iowa or some such place. On the one side you had relatively low production per labor hour and on the other an enormously high rate of production per labor hour, but based on capital outlays for the equipment like the John Deere tractor, well into six figures. The Marxist idea of how capital makes money from labor is that capital — that labor is a commodity and the labor theory of value more or less applies to that commodity. How much do you have to pay for the commodity which he calls labor power or laboring powering? Well you have to pay what it costs to feed the worker, to clothe the worker, to rear his or her children, you have — the analogy is imagine you have a plow horse, what does it cost you to maintain the plow horse? Well that same reasoning Marx applies to the workforce. You pay wages that are broadly consistent with that. In my diagram the laboring power is represented by the blue and capital pays labor that much for its activity. The total pie represents how much value is produced by labor and what’s left over is called surplus value. The capitalist firm keeps the surplus value, by that means exploits labor, and by that means increases its wealth to create wealth.

Now that leaves out a lot. One thing it leaves out is the fundamentals of supply and demand for labor. It doesn’t take into account the idea that labor would be extremely cheap in this phase — how many people here haven’t seen the demographic transition? Good, because we did it a couple days ago, but I never know about turnover. Marx is oblivious to that except how would he answer if I said that? He would say, well no labor is cheaper in these conditions because the socially shared expectations for how well they have to be fed, clothed, and their children reared are low in those conditions. Village India, the cost of labor power is vastly less then it is in Midtown Manhattan; that’s one issue.

Another issue, this is the age curve, and it’s just an embellishment of the demography. Another is how hard people work; this is a Breugel sixteenth century picture of agricultural labor, which by the evidence there is not very intense. The idea that you pay for what you get in labor is a powerful one, and the so-called scientific management movement of a century ago, which grew up around large manufacturing companies in the U.S. and Europe, was that you develop incentives to make people work really hard. The simplest case was Henry Ford’s $5 a day salary, which was way above market prices, but allowed him to be very choosy about his workers, to demand very intense labor, and to demand that they allow him to inspect their lives. He had what he called sociologists who went around to people’s houses looking for alcohol or devices for gambling and so on but intensity of labor is another variable that needs to be thought of.

Now I just made that story sound really sensible, I think, but the logic of it has always escaped me. The notion that labor is different from any other standard for measuring value and that you can — you attribute to labor the whole pie, but actually you’ve got to attribute much of the pie to capital. Beyond capital you’ve got to attribute much of it to ownership and to management, and intellectual property. Knowhow, the ability to actually made widgets well and effectively at low costs, all that is left out of Marx’s story.

He assumes, he just says, “necessary labor time” and draws attention away from what capitalism is best at, which is again and again revising the way we produce something, the way we distribute it, the way we design it, the way we design the machinery that creates it, even the way we design the machinery that designs the product, all of that is marginalized in a Marxist analysis. And for that reason Marxism does not function well in analyzing real companies in real markets. Now the surplus value that can be extracted depends on how much labor is used in production. As total labor used in production goes towards zero, the opportunity to exploit workers goes away, and with it profits have to fall.

Chapter 5. Immiseration of the Working Class in Late Capitalism [00:34:42]

And from that follows the evisceration of the working class. Look at this bottling plant where the work is to sit at this control panel and adjust the process, plus a little maintenance. Have any of you been in a plant where there were virtually no workers present? Can you hand him the microphone?

Student: It was the Celestial Seasonings tea factory in Boulder, Colorado. It’s just machines putting — sorting leaves, putting them into bags. And there are like three or four workers in this huge room sitting at this screen adjusting (inaudible).

Professor Douglas W. Rae: Right, exactly. Other examples? In the back, can we get a mic back to the very last row?

Student: I took a tour of the Tsing Dao Beer Factory in China. I mean, it’s fairly old, I mean, the only people working there were tour guides and inspectors that were within the [inaudible].

Professor Douglas W. Rae: So a very high degree of automation?

Student: Yes.

Professor Douglas W. Rae: I was some years ago in a textile factory in Turkey, which covered six acres of interior manufacturing space. Every square foot of it was either an aisle between machinery or machinery, and virtually all the machinery was working, and the cloth was coming out in bolts like this at ten or twelve different points, and automata were throwing it on conveyer belts, and conveyer belts were taking it where it needed to be for shipping, and labeling it and having it ready to go. When I was there, there were about six people in the plant, all of them technicians and the story about the plant was that it could operate that way for as much as 60 hours and then there would be a shutdown for a few hours of maintenance and adjustment, and then another 60 hours and so on.

Another historical example is the Bonsack Cigarette Machine; cigarettes were not popular before the Bonsack Cigarette Machine. The Bonsack Cigarette Machine could make 6,000 cigarettes per hour, which — they’re now much better than that, they’re 100,000 an hour — but at 6,000 per hour with zero labor cost, it occurred to the people who formed American Tobacco that they could make an awful lot of money if they created a marketing end, that would allow them to pump all those thousands of cigarettes out into the market. And they did it, and did a very good job of it. At the core of it was this little piece of technology, continuous production, and paper and tobacco leaf go in one end of the machine, and cigarettes neatly stacked in consecutive order come out the other. So capital intensivity takes labor out of the picture. In effect, the dead who created the machinery are the producers.

Chapter 6. Inevitable Revolution in Advanced Capitalist Systems [00:38:30]

Inevitable revolution in advanced capitalist societies. The idea here is that with falling rates of capital and the immiseration of the working class, this system ceases to be stable. This is a guy named Georgi Plekhanov, and Plekhanov was a Marxist who was a follower of Lenin’s, and he’s famous for having asked the question, “If the revolution is inevitable, why must we fight and die to make it happen?” That’s an interesting question, and it gets the name Plekhanov’s paradox. And of course the answer to it is that the revolution wasn’t inevitable. Where it did happen, it didn’t happen for the reasons Marx described. Where were the most advanced systems where you would expect the capital intensive production, falling rate of profit, and low wages to labor, where were those systems? Let’s name a few countries. Yes.

Student: UK, Germany and the U.S.

Professor Douglas W. Rae: UK, Germany and the U.S. Those are not the places where the revolution happened. It happened most dramatically in Russia, and then by conquest in the rest of the Soviet Union, and Cuba. This is Fidel on the right and Che Guevara on the left. There was — I have a photograph in my collection at home of Fidel Castro at the New Haven train station and a New Haven policeman looking at him like he’s from Mars. And it was just after the revolution when they hadn’t — when the break with the U.S. hadn’t really hardened, and he was on a university tour speaking on college campuses trying to raise money for the revolution. Cuba was not an advanced capitalist economy and still isn’t. The best thing you can say about — I’ve been twice and have been a guest of the government once, and the best thing you can say for them is that they actually have done a splendid job with rudimentary public health, so that on the longevity dimension of the data automation we looked at, if you’ll screen it up tonight you’ll discover a little green moon way, way high side outlier on longevity, and that’s Cuba. On the other hand they are dirt poor. China, not an advanced industrial economy when the revolution occurred; Venezuela, an oil state, and whether the revolution has occurred or not is open to question. And this at the height of the Cold War was the way the chess board looked, where red meant Marxist and pink meant sort of Marxist, and the game of controlling emerging market countries was at the core of Cold War strategy or very near it.

Chapter 7. Theory of the Universal Class [00:42:06]

The theory of the universal class. If the aristocracy exploits serfs in medieval European society, and capitalists exploit proletarians in capitalist society, and proletarians come to power, who are they going to exploit? There’s no one below them. Since there’s no one below them they are the universal class and exploitation is over. Now please. So the reasoning is like the eastern division of the American League, and Baltimore is the universal class because there’s no one they can beat. What’s at the core of this last thing, and it is truly dangerous reasoning, is that the universal class, being in a position superior to no other class, brings an end to exploitation.

Chapter 8. Withering Away of the State [00:43:23]

And since that’s true the state can wither away.

Now it doesn’t happen in a hurry, and behind this is a really fundamental issue of principal agency. Did we talk about principle agency a few days ago? Maybe not, well let’s just for simplicity, let’s suppose the people own the country and the Communist government is the agent that they have elected to choose, or which has chosen itself to manage the country on behalf of the people. The principal agency problem which occurs in things as small as a grocery store is that the employee’s agents choose, instead of serving the purposes of the owners or the country, choose to serve purposes of their own. The invariable fact about state socialism was that the people at the top of the state apparatus privileged themselves and their children, and a new class struggle developed.

Now, more generally and here I’m using the work of a sociologist named Ralf Dahrendorf, economist sociologist who died just a few weeks ago, and Dahrendorf’s point, which I’m sure is true, is that you can generate classes around any process of production and distribution. There is nothing final about the proletariat coming to power, and there is never a time in human history when we’ll be done with the possibility that those who control the direct levers control them not to the benefit of others, but to the benefit of themselves. Francis Fukayama, who famously wrote a book called — that had the punch line: The end of history — after the Cold War ended — his view was that capitalist democracy became, “the end of history,” the unchangeable endpoint, and of course that’s not true. The course of history is not, contrary to Marx, determinate. Marx was not only wrong about his own ability to understand the course of future history, he was wrong about the very concept that there could be a deterministic theory which told us what was going to happen in the future. This guy, Schumpeter, who, I know you hate the way he writes, but he understood that point profoundly. I’m out of time so I’m not going to elaborate him, I’ll do it at the beginning of class next time. The guy who comes to center stage next time is F.A. Hayek, whose most famous book was called, The Constitution of Liberty, and who believed that a market society had within it the capacity for enormous creativity and growth, and we’ll examine that in class on Wednesday.

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