HAYEK ESSAY CONTEST 2010

by the Mont Pelerin Society

Examine whether authoritarian capitalism is a viable alternative to its Western liberal version, to promote long term economic growth and development.

An essay by Paul Schmelzing 4.929 words

Contact details: Paul Ferdinand Schmelzing Sbener Str. 25 81547 Munich, Germany psilmer@hotmail.com

Contents

Introduction.1 On innovation and the catallaxy..2 Nomos and private property....4 Lessons from cybernetics.6 On China.....7 On intellectual development.8 Conclusion..9

Introduction
When we are to discuss the merits of the Western liberal version of capitalism in comparison to authoritarian counterparts, we should attempt to define them first, not because we cannot rely on our intuitive knowledge, but rather because the very existence of the term authoritarian capitalism is proof that boundaries between traditionally opposed theories have been watered down. This is not to say that hybrid versions that seek to merge ideas of classical liberalism and political collectivism are a phenomenon only of recent times and that there has not been extensive intellectual debate about the third way. Yet while the concept of market socialism or competitive socialism, as Hayek called it, has indeed been known as early as the 1920s, not least socialists themselves would insist that contemporary models followed by countries like the PRC or Vietnam are markedly different.

Isaiah Berlin in his famous essay on the Two Concepts of Liberty distinguishes negative from positive liberty, the former being concerned with the actual extent of personal freedom, the latter with the question of who holds power and is entitled to rule a society. It is of paramount importance to note that capitalism as an economic concept is indifferent to positive liberty. The central mechanisms of private property, contractual rights and the instrument of competition are not affected by the form of government established in a given society. Democracies, Monarchies and even dictatorships can, in principle, be reconciled with them. As Berlin states, referring to Benjamin Constant, () the main problem for those who desire negative, individual freedom is not who wields this authority, but how much authority should be placed in any set of hands. () Democracy may disarm a given privileged individual or set of individuals, but it can still crush 1 individuals as mercilessly as any previous ruler. The standalone characteristic of Western, liberal capitalism will thus be the conjunction of an economy based on private property and competition merged with free and competitive positive liberty based on the separation of powers. We should now refine the term authoritarian capitalism as it can, in my view, have two distinct meanings and the difference is a crucial one to make. It depends on the decision if we examine a society holistically, or if we focus on the economic sphere alone. At a later point, I will explain why the distinction is desirable only from a special point of view. In the first version, an illiberal political system would operate alongside a liberal economic system, that is, political repression would be combined with truly laissez-faire markets. Areas where political and economic competencies overlap, like private property or monetary policy, would be regulated in favor of nonintervention, so that highly restricted positive liberty is accompanied by total economic negative liberty. Hence, if we attempt to answer the question if capitalism in a collectivist political system is an alternative to it in a democratic environment, we have to conclude right at the beginning that, given equal negative liberty, 2 long term growth and flourishing (economic) development is just as likely in both of them .

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Isaiah Berlin: Two Concepts of Liberty in Liberty, Oxford University Press, Oxford, 2008, p.209 It was also Constant, who pointed out that authoritarianism, to whatever extent, creates undesirable personal traits in those affected by it. Those traits, of course, can have considerable influence on the economic dynamism. (see also the chapter On intellectual development)

In the second concept, business affairs would not be left unfettered, but rather the authoritarian regime would retain a veto power over major directional issues in economic policy, intervene into the distribution and pricing of the means of production and create public companies that operate alongside private competitors. Restricted economic negative freedom is implied and within the economic sphere, authoritarian and liberal forces are combined. Here, the scope of intervention determines if the overall structure can be considered 3 capitalist . For the moment, when we speak about authoritarian capitalism, we will be concerned not about the value of a democracy in contrast to despotism, the right of power, but rather about the inalienable power of rights and the scope of (economic) frontiers that protect free exchange.

On innovation and the catallaxy

Pioneering work conducted by Robert Solow in the 1950s paved the way for what is now conventional wisdom: it is the improvement in total factor productivity (TFP) that accounts for the most part of overall economic growth, in the case of the US for 80% of it. Subsequent authors in their endogenous growth model stressed that policy determinants influencing performance were openness to international trade, tax incentives to start 4 businesses and the fostering of competition . Countries like China, India or those in Latin America with their huge labor forces, current-account surpluses and a lot of catch-up potential in terms of purchasing power can rely on growth strategies that focus on scope (labor/capital input) and cheap exports for some time, only that this does not in any way represent a (longterm) competitive edge. Growth will be impressive but, without radical adjustments, short lived. Export performance will depend on the critical ability to maintain weak currencies and significant proportions of the workers accepting wages below global averages. Yet artificial undervaluation is likely to cause conflicts with trading partners and will be difficult to sustain in the long term. Equally, labor is poised either to shrink or to accept stagnant distributions of national income on a low level, fuelling social unrest. If a country has higher ambitions than to stay at the bottom of the global wage pyramid, the only way to do so peacefully and in line with intellectual property rights is to sponsor entrepreneurialism and innovation. 5 Once the natural asymptote has been reached, brutal force has to be replaced by smart growth. And smart it has to be, for most of the authoritarians have bound their political fate to the delivery of startling rises in living standards. What is often neglected in the debate about the impressive economic statistics in authoritarian capitalist societies, therefore, is that the weight of its different factors will eventually determine the long or very longterm perspective and not growth per se. Secondly, Samuel Huntingtons view keeps being echoed in recent literature in the way that countries will inevitably turn democratic once a threshold of a particular per capita income has been passed; given the above argument, the measure should probably be refined to the point where scale input has reached its limit and gains in TFP have to make up the difference to keep growth at constant rates at least.

Additionally, in socialist authoritarian regimes, capitalist elements are, officially, only of a transitory nature and ought to be replaced by collective means again once a higher stage of development is reached. Here also lies the key difference to market socialism. 4 See: William Baumol et al.: Good Capitalism, Bad Capitalism, Yale University Press, New Haven (2007), pp.39ff. 5 Ibid., pp.20ff.

Still, some authors argue that state-induced innovation and entrepreneurialism along party lines will do just as well and allows authoritarian capitalists to avoid losing political grip. They believe it is possible to plan an innovative society on the scratchboard in party bureaus and order inventions to happen.

Why are the principles of innovation in conflict with that of authoritarian capitalism?

The spontaneous order any innovator is about to enter is a fundamental precondition for the commercial viability of a project. While he cannot expect to take risk out of the equation, to make success possible and the 6 rewards worthwhile, he has to be able to rely on a grown conduct that allows him to foresee reactions by other participants, including institutional players. While the individual might enter the market having specific ends in mind, all he can exchange, and all that his counterparts will trade and barter, is means. Means that can serve various ends, sometimes ends that even oppose each other. He will find that no moral or value judgments are made upon him. As much as it can act as an agent of vice, the market can act as an agent of virtue. What a catallaxy will bring about, then, is first a plurality of values in ends. Such diversity, apart from being for many a wishful trait in itself, makes it much more likely that a shift in demand can be accommodated, because some actor will probably supply just the good or service required by others. Additionally, as a greater number of different ends is being pursued, more means will be offered by others to reach those. The more paths that are available, the more likely it is that some will prove superior to former ones. More and more, those relations will create a self-improving process, as it is realized that means originally intended for a specific purpose can serve to enhance various additional ones as well. A system that consists of autonomous individual actors communicating with each other through the price mechanism can adjust very quickly to exogenous (political conflicts, natural disasters, international relations) and endogenous (technological innovation, financial crashes, bankruptcies) events, with each participants reaction rippling through the market with lightning speed via financial markets, like a game of pool.

In contrast, if necessary adjustments have to be approved by an authority, which has to reach decisions relying on imperfect knowledge and in line with certain preferred (and often arbitrary) ends, those reactions will ripple through the market blow by blow, resembling a game of bowling, and economic actors will often be forced to 7 abstain from undertaking ventures in the first place because the risk cannot be accommodated . It is hard to measure the forgone social benefit as we will never know which enterprises would have been created in the absence of interventionism, but it is telling that indexes measuring global innovation and those measuring 8 economic freedom feature almost the same countries performing well . Public institutions with the power to approve certain actions are certainly not a standalone attribute only to be found in authoritarian systems. Western economies employ similar prohibitions when we think of the energy
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Which, when institutionalized, will make up the legal framework. This phenomenon is, I believe, akin to the concept of diversification in finance. While the very existence of a pluralized and autonomous market will spread shocks among a variety of economic actors as it acts as an impersonal counterparty to numerous participants, an authority bundles the event and targets a few preselected actors. It has little means to spread an event if it is to be acting on ends. 8 Compare, for example, the Global Innovation Index, compiled by the Boston Consulting Group and the Index of Economic Freedom by the Heritage Foundation. 18 of the 25 countries with the highest economic freedom are also among the 25 most innovative countries. http://www.heritage.org/index/ranking.aspx, http://en.wikipedia.org/wiki/Global_Innovation_Index , both visited on May 21, 2010.

or pharmaceutical sectors. Although the scale of that veto power is a key difference here, another element embraced by authoritarian regimes is more decisive: the need to intervene in the price mechanism. To create a stronger identification between rulers and those ruled, authoritarian regimes seek to let nationalism work in their favor. One way of channeling pride is to create national champions, huge conglomerates that are recognized internationally and frequently make the headlines. It is no coincidence that the strategic sectors in which they engage are those with vast influence over the distribution of primary means of production, i.e. commodities, the financial industry and utilities. In most cases, the discussion about their distributive targets does not even enter the socialist calculation debate, that is, the question whether those firms should try to simulate prices which would evolve under strictly competitive conditions. It is clear from the beginning that they serve as the visible hand of governments and are used discriminatorily to transform longterm economic planning set about by bureaucrats into day-to-day operations. Again, statistics do not tell the whole story. The comparison between the market share of public companies versus that of private ones is not a good indicator of how liberal a market truly is. We would suffer from what Hayek called synoptic delusion if we believed all the individual actions that depend on a certain economic signal can be both quantified and qualified. An individual might know that a price signal he gets does not reflect the actual relation between supply and 9 demand. But it is almost impossible for him to calculate what the price should be without that distortion . Additionally, his decision to abstain or engage in a specific way is an indication for numerous other actors he might not even be aware of, to pursue different ends. The outcome is a distorted chain of events, a butterfly effect that leads to massive aggregated misallocations, the most visible of which manifest themselves in financial or housing bubbles. Liberal capitalist societies will equally experience recessions, but not only can they can built on a Schumpeterian catharsis in the aftermath as the number of market participants and the diversity of means and techniques allows them to switch the allocation of resources much more smoothly. Also, crucially, they can do so within the existing political framework.

Nomos and private property

Grown common rules that guide a groups behavior underlie made laws, incorporated by the legislator. Authoritarian capitalist societies turn that relationship upside down: lawmaking becomes detached from 10 common rules . Additionally, the laws themselves are designed not to be applicable to a great number of unknown beneficiaries and serve unknown ends, but rather to leave enough room for their governments to retain their influence through more subtle mechanisms than plain top-down direction, for the sake of attracting as much liberal-minded investors as possible (and for being able to blame others should things turn nasty). Here, not traditional consent between parties, not trust, not even common sense necessarily determines what can be expected of other actors in a market, but rather a procedure that for the most part is intended to serve a case-by-case evaluation as broadly as possible. Of course, it is not before long that the actual unreliability is realized as such by economic actors. In what way would they adjust their behavior?

The same is true for institutions, and that is why Oskar Langes concept of market socialism will only work in theory. 10 F.A.v.Hayek: Law, Legislation, Liberty (Vol.1: Rules and Order), Routledge & Kegan Paul, Chicago (1973), p.95

The most important implication is that property rights are arbitrary and that the division of property cannot act as a counterweight against political power. Weak property rights, though, mean many small or young enterprises run by self-employed locals have no choice but to abstain from behavior that might lead to ruinous outcomes, behavior that often would have been 11 their only way to realize social mobility and innovation . To improve their condition, individuals will necessarily have to try to establish preferential relationships with judges and officials, through bribery, personal contacts or other semi-legal means. As Hayek observes, in a planned society all our efforts directed towards improving our position will have to aim, not at foreseeing and preparing as well as we can for the circumstances over which we have no control, but at influencing in our 12 favor the authority which has all the power. This practice is particularly discriminatory against those with low incomes, as corrupt officials will typically auction their decisions. Contrary to common belief, therefore, planning will not lead to an equalization of wealth, but rather to a fostering of inequality with those at the top doing ever better, as they will also be able 13 to buy certainty, and those at the bottom being rid of any means or incentives to improve their condition .

In the wider marketplace, the entry barriers are raised and even for successful entrants, arbitrariness dominates the day. Larger corporations probably find it easier to establish connections to officials and are more able to absorb legal defeats. Some will simply resort to paying bribes. In many cases, this leads to oligopolies or even state-sponsored monopolies. Without significant external pressure, the lucky insiders have no real incentive to drive prices towards marginal costs. The tighter the relationship between individual companies and the planning authorities up to the extreme cases of State-owned Enterprises (SOEs), the greater the risk of moral hazard. With transparency being a rare good among collectivist societies, the financial damage created by these implicit guarantees will seldom find its way into the eyes of public scrutiny, but there can be no doubt that the costs must be immense. The East-Asian Crisis of 1997-98 and huge problems in Chinas and 14 Japans banking sector over the last decades are perfect examples .

Corruption is sometimes seen as a secondary, standalone factor to be aware of, something that has to do with the culture of developing societies and which can be reduced by stricter penalties and more transparency. But the direct relation between laws of deliberate design and discriminatory markets, should make it more obvious that the underlying problem is a fundamental one: corruption is a symptom closely connected with what Hayek called the errors of constructivist rationalism () with the conception of an independently existing mind substance which stands outside the cosmos of nature () to design the institutions of society and culture 15 among which he lives. Accordingly, the impact of corruption on general welfare is far from secondary: studies estimate that 16 corruption in China alone knocks off up to 17% of GDP.

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Real numbers confirm that corruption is particularly discriminatory against small and young companies. Among other indicators, for example, the rise of corruption in the PRC has been matched by a steady decline in self-employment businesses. See: Yasheng Huang: Capitalism with Chinese Characteristics, Cambridge University Press, Cambridge (2008), p.236 12 Hayek: The Road to Serfdom, Routledge & Kegan Paul, Chicago (2007), p.138 13 Accordingly, the gini coefficient, which measures income inequality is higher in planned economies like China (46.9) than in any Western, liberal society (the highest being the US with 40.8), see: http://en.wikipedia.org/wiki/List_of_countries_by_income_equality , accessed 05/26/2010 14 Baumol et al., p.68 15 F.A.v.Hayek: Law, Legislation and Liberty (Vol.1: Rules and Order), Routledge & Kegan Paul, Chicago (1973), p.17 16 Stefan Halper: The Beijing Consensus, Basic Books, New York (2010), p.165

Lessons from cybernetics

It is quite interesting that Hayek in his section on The Market Order or Catallaxy refers to cybernetics when he describes the process of learning by individuals in an evolving market. Hayek states: The process of adaptation operates, as do the adjustments of any self-organizing system, by what cybernetics has taught us to call negative feedback: responses to the differences between the expected and the actual 17 results of actions so that these differences be reduced. Self-organization studies the behavior of systems of distributive control that give rise to overall properties . Its findings hold remarkable insights for the question if and how a spontaneous order is superior to a system of human design with centralized planning. Analogies in this field may illustrate the points made earlier about how interventions in the price mechanism and market entries create disturbances in the macro-order. Self-organizing systems are characterized by their general non-linearity, which means that reactions are often not proportional to their causes. The individual elements are connected with each other through a certain process, in the catallaxy through the flow of information. The latter adjusts the behavior of its elements, either in a reinforcing (positive feedback) or a suppressing (negative feedback) manner, with each agent sending and receiving data at the same time. Because the relationship between the agents is thus a circular one, even tiny fluctuations can, through feedback loops, produce significant modifications in a subsequent structure. Some interventions in the catallaxy discussed are endogenous (national champions) and will therefore alter the solution (here: the ends pursued by economic actors) of the system, although this state cannot be predicted a priori. Another aspect makes them much more destructive, though. A pricing policy that establishes artificial equilibria and is hostile to decentralized innovation will disturb the crucial adaptation process, because it leads to changes in the boundary conditions and, ultimately, to disintegration as the system is prohibited from using its learning capability. In more technical terms, price interventions limit the variety of states a system can choose from and 19 increase perturbations from a goal configuration that endanger the essential organization. A central planning agency, whose aim is to preserve the global order, thus needs to constantly counter perturbations itself, spot them in their initial stages and simulate the myriads of feedback connections. Even if we would assume that such a system would work, which, it is safe to say, is impossible (again, see the synoptic delusion argument), it would not only import entropy, but do so at enormous costs for both agents and the agency.
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Hayek, Law, Legislation, Liberty (Vol.2: The Mirage of Social Justice), Routledge & Kegan Paul, Chicago (1976), p. 125 18 A short introduction by Francis Heylighen is available at http://pespmc1.vub.ac.be/papers/EOLSS-SelfOrganiz.pdf 19 Ibid., p.15f.

On China

It is vital to apply the abstract discussion to an actual contemporary case, as many people will contend that the above arguments are proved wrong by simply turning to actual trends at the world stage. By far the hottest topic of the recent literature about the rise of developing countries is the success of the PRC since Deng Xiaopings market reforms beginning in 1978. Each day, they say, we see the staggering success of China in getting hold of natural resources, attracting capital from all corners of the earth and beating the West at its own game, by replicating the juicy bit, capitalism, but retaining political repression. Stefan Halper echoes a common perception when he asserts that the terms, the conditions and arrangements, of state-directed capitalism give Beijing a distinctive edge over Western competitors. () the age of Westernstyle privatization and deregulation unleashed by Margaret Thatcher and Ronald Reagan in the 1980s is giving way to a world in which governments use their strength to buy assets or exert global influence. But those events also signal the end of optimistic expectations about the transformative power of markets to globalize 20 the principles of the European Enlightenment. Some indicators mentioned earlier should already put the China-hype into question, especially regarding its long-term prospects. But the discussion is flawed in a more fundamental way. First, when we define a capitalist economy according to the measures laid out above, the claim that China replicated Western capitalism is dubious. Indeed, the Heritage Foundation in a 2010 global survey finds that 139 economies are more liberal 21 than Chinas . Only in the category of government spending does it excel the global average. The rest of the picture is summed up in gloom-and-doom language: Investors face regulatory nontransparency, complex and inconsistently enforced laws and regulations, weak protection of intellectual property rights, corruption, industrial policies protecting local firms, and a legal system that cannot guarantee the sanctity of contracts. Chinese entrepreneurs cannot freely enter at least 36 sectors because of legal prohibitions and numerous individual cases are documented where they are turned away by the inability either to make risk-taking 22 worthwhile (uncertainty if they can hold on to property) or to pay the highest bribes . We should think twice before considering such an environment capitalist and we should be more cautious about the claim that in China there exist markets with a potentially transformative power in the first place, before rendering them invalid. Yes, it is true that by ignoring the ethical standards that often prevent Western governments from dealing with other authoritarian regimes, the PRC has been quite successful in securing access to commodities, whether in Sudan, Venezuela or Iran. But as long as their domestic markets are wasting their potential by denying investors legal predictability, equal access to the means of production and are unable to unleash an innovative spirit, Beijing is throwing good natural resources after bad economic policies. The capitalist elements that China undoubtedly introduced focused on establishing itself as an internationally competitive export hub for low-cost consumer goods, and now focus on maintaining and extending that position, but my view is that those elements are not sufficient to label its economic system capitalist according to the definition introduced at the beginning of this essay. If China will make the transition to an authoritarian capitalist society will critically depend on its ability to move its export goods higher up the value chain.
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Halper (2010), p.103 and 121 2010 Index of Economic Freedom, China country spreadsheet. Available at http://www.heritage.org/index/Country/China 22 Minxin Pei, Chinas Trapped Transition, Harvard University Press, Cambridge (2006), p.32

Such a waste of capital and natural resources helps explain why some authoritarian countries manage to 23 achieve impressive growth rates while at the same time personal incomes underperform or even stagnate . Contemporary literature should, hence, focus more on the latter indicator as a measure of economic success. While in democracies there exists no grand economic bargain between the people and governments, and sluggish growth will not necessarily be blamed at politics, authoritarian governments base their legitimacy on delivering ever rising living standards. The more centralized control is, the more people will vent their anger at governments once the performance turns sour. Chinas thirst for commodities, for example, can be explained by the need to push scale input higher and higher so that political obedience is not being put into question. The fact that people will not tolerate deadlock means that authoritarian governments will be tempted to increase their control over the economy even more, leading to greater waste of capital, less innovation, more pressure on long-term growth and so forth. That means that under authoritarian political conditions in the long-term, economic growth and social stability are, ultimately, negatively correlated.

On intellectual development

So far I have elaborated on the merits of innovation only in a specific sense, to show its benefits for economic development. Yet innovation is just a small part of the general intellectual engagement that can be used for a much greater number of purposes, including literature, art or science. Once more we should turn to Benjamin Constant who states that Nature, when creating men, did not consult the authorities; it ordained that all our faculties should be intimately bound together and that none of them could be constrained without affecting the others. () As paralysis spreads from one part of the body to 24 another, so it spreads from one to another of our interests. It seems to me that his observation is more important than all other aspects so far. Cultural existence thrives by the interplay of ideas, discoveries and enjoyments from the whole range of possible activities. Although rising living standards satisfy basic needs of men, beyond mere subsistence they can never be a full substitute for the plethora of means for the most important desire of them all: individual self-realization. At the beginning of this essay, I have introduced Isaiah Berlins Two Concepts of Liberty and, for the formal evaluation of the topic, distinguished negative from positive liberty. This separation is still very useful for a treatment of all the features that can be measured, quantified and laid out in front of us. There are solely economic motives in people, regardless of the extent and of the specific goal they have in mind. But the common denominator that bounds both concepts together and which makes the distinction hard to justify is human nature itself.

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For China, see: Huang (2008), p.241 Benjamin Constant: Political Writings, Cambridge University Press, Cambridge (1988), p.122

Conclusion

I have sought to outline three major arguments: 1. That, although liberal philosophy contends that economic freedom will promote the desire of individuals for freedom to be extended to political affairs, a capitalist economy can coexist with illiberal political systems, although probably only for a limited period. That the restriction of negative liberty in the realm of economics will create disorder, ineffectiveness, stagnation and a gradual aggregation of individual disappointment. This does not preclude the possibility that a short-term exploitation of human capital and natural resources will create impressive growth rates until scale input is exhausted. That China does not qualify as an example of a successful authoritarian capitalist system.

2.

3.

Accordingly, the long-term growth and development of authoritarian capitalist societies will come under serious pressure from two broad dynamics. One is purely economic, the other what we might call a humanpolitical one. Both will mutually reinforce each other over time and culminate in grinding progress to a standstill. The economic challenges mentioned in (2.) will all be serious obstacles in the need to switch to smart growth and also challenge the view often heard nowadays, that the drawbacks of democracy compared to illiberal societies include slow and populist decision-making processes which threaten political stability. A downside of merging politics and economics is, rather, that crises in one of them spill over to the other much easier. Such crises in the economic sphere are more likely to happen in authoritarian regimes as allocative perturbations are commonplace and harder to tackle. Crises in the human-political sphere, too, are more notorious because the inability of authoritarian capitalism to either improve social mobility and ensure ample rewards for risk taking or truly equalize incomes, will lead to growing frustration among wide parts of the population. Of course, both economic and human-political crises are only manifestations of a more fundamental impediment: the restrictions on human nature. With this in mind, we now have reason to concur with Hilaire Belloc, who concluded that

The control of the production of wealth is the control of human life itself. 25

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The quotation can be found in F.A. Hayek, The Road To Serfdom, University of Chicago Press, London, 2007, p. 124