This was published in the Financial Times.
Democracy and free enterprise usually are found together – it is hard to think of any flourishing democracy that is not a market economy. Moreover, while a number of autocratic economies have embraced free enterprise (or “socialism with Chinese characteristics,” as the Chinese Communist Party would say), it seems to be only a matter of time before they are forced to become more democratic.
Yet it is not clear a priori why democracy and free enterprise should be mutually supportive. After all, democracy treats individuals as equal, with every adult getting an equal vote, whereas free enterprise empowers individuals based on how much economic value they create and how much property they own.
What then prevents the median voter in a democracy from voting to dispossess the rich and successful? And why do the latter not try to erode the political rights of the former.
One reason that the median voter rationally agrees to protect the property of the rich may be that she sees the rich as more efficient managers of that property. So, to the extent that the rich are self-made, and have come out winners in a competitive, fair, and transparent market, society may be better off allowing them to own and manage their wealth, and getting a reasonable share as taxes. The more, however, that the rich are seen as idle or crooked – as having simply inherited or, worse, gained their wealth nefariously – the more the median voter should be willing to vote for tough regulations and punitive taxes on them.
In today’s Russia, for example, property rights do not enjoy widespread popular support, because so many of the country’s fabulously wealthy oligarchs are seen as having acquired their wealth through dubious means. They grew rich because they managed the system, not because they managed their businesses well. When the government goes after a rich oil tycoon like Mikhail Khodorkovsky, few voices are raised in protest. And, as the rich kowtow to the authorities to protect their wealth, a strong check on official arbitrariness disappears. Government is free to become more autocratic.
In contrast, under conditions of fair transparent competition, the process of creative destruction tends to pull down badly managed acquired or inherited wealth, replacing it with new and dynamic wealth. Great inequality, built up over generations, does not become a source of great popular resentment. On the contrary, everyone can dream that they, too, will become rich.
When such aspirations seem plausible, the system gains added democratic support. The rich, confidant of popular legitimacy, can then use the independence that accompanies wealth to limit arbitrary government and protect democracy. Free enterprise and democracy sustain each other.
All this suggests that there are deeper reasons for why democratic systems support property rights and enterprise than the cynical argument that votes and legislators can be bought, and the capitalists have the money. The cynics can only be right for a while. Ultimately, a capitalist system that does not enjoy popular support loses any vestige of either democracy or free enterprise.
There are two important challenges to the legitimacy of capitalism in the West today. First, it no longer seems to provide equal opportunity to all. The recent crisis has raised questions about how at least one segment of business – the bankers – makes its money, with the suggestion that sharp or even illegal practices, and implicit government support, rather than customer value, has been the source of banker fortunes. At the same time, the prospect of riches seems to be slipping out of reach for many in the middle class, in part because a good education, which increasingly seems to be the passport to prosperity, is unaffordable. All this erodes support for the free-enterprise system.
A second big challenge, however, is the coming selective enforcement of property rights. In the prosperous 1960s, Western economies bought social cohesion by making extravagant promises to their people on pensions and healthcare. Subsequent slower growth, exacerbated by the recent crisis, and followed by bank bailouts, have raised the level of public debt substantially. Adding up all government promises, they are unaffordable in a number of industrial countries. Because governments need to borrow, they will try to renegotiate their longer term pension and healthcare commitments, even while continuing to service debt. Again, the appearance that the claims of rich investors (who are typically more directly and heavily invested in bonds, as also earlier invested in bank claims) are being favored at the expense of those of the wider public (for whom pension and healthcare claims form a larger portion of their assets) cannot but erode support for property rights.
To restore legitimacy and support for the system, industrial economies have to restore opportunity to the middle class, by working hard on improving education and helping create the support structures that allow people to train for, obtain, and hold on to good jobs. They also have to explain why some government promises are more equal than others, and why it is not just the plutocrats who benefit. These are not easy tasks but they are essential if they want to remain functioning market democracies.