Journey to the Present Economic System

Journey to the Present Economic System

Introduction

We are living in a time when the system of Capitalism reigns supreme amongst all competing systems of social and economic management.

If we are to appear credible in unravelling the deeply entrenched dogma of the Capitalist system, we have to start by understanding it deeply and to do that, we have to appreciate the journey to the current mainstream economic thought and show how it is not fit to meet the challenges of the present and future scenarios that it will encounter. 

Background to Capitalism

There have been several preceding chapters leading up the birth of the Capitalism system that we know that are worthy of mention very briefly. This is to appreciate how much Capitalism is appreciated today from the past systems which are considered in retrospect to be fundamentally flawed but suited for the unique circumstances of the time.

Let us start the journey from the Feudal system which gathered momentum when Christianity came to the shores of Britain and started to replace the disparate kingdoms under the Anglo Saxon paganist rule after the demise of the centrally controlled Western Roman Empire. The Feudal system really took its form due to the rule of William the Conqueror after the battle of Hastings in 1066.

With the demise of central structures, the Christian Kings of Europe found it difficult to maintain their dominium’s and due to the nature of land conflicts and constant threat of invasion at the time, the masses found it difficult to secure much needed protection. Feudalism solved this problem by allowing the peasants to be protected and for the kings to allocate land to nobles  and by so doing allocate them a share of the wealth and for these nobles , via Knights, extract labour services from the peasants and protect them from external attacks. This was a symbiotic relationship with agrarian services being rendered in response to being protected. The boundary of this system was the manor and trade and interaction beyond this realm was limited.

The system worked until the Protestant reformation when the central Roman Catholic Church lost its influence across Europe and regional Kings sought to gather their newly acquired independence from Roman control at a more national level under the next system called Mercantilism.

Mercantilism is based on maximizing exports and minimizing imports and amassing the resulting gold and silver coinage. It views trade as a zero sum game, i.e. one party cannot become better off without making the other party worse off. Production was essentially controlled centrally and for the benefit of the nation using the mercantilism corporation for example the East India Company that was the doorway into India’s colonization. This system started from the later 16^th Century and lasted around 250 years and coincided with the rise in Colonialism.

Birth of Capitalism

This is when the Capitalist chapter starts with the work of Adam Smith in his seminal book the Wealth of Nations in 1776. His school is known as the Classical School of Economics and introduced a profoundly new idea into the discourse when fundamentally shifted the paradigm from all that preceded it.

Question: What was this fundamental shift which still provides Capitalism with its appeal?

Smith postulated that trade was not a zero sum game and all parties could simultaneously benefit from specialisation and free trade. This idea was radical at the time and was the catalyst that ended mercantilist policies at least domestically although the colonial face of the Western powers lasted much longer. He said that the free market was guided by an “invisible hand” that ensured that all market participants would rise as a result of everyone pursuing their self-interest. He called for the division of labour or specialisation, both at an individual level and country level to maximise the benefit to all market participants. The idea being that one focuses on what one is best at (have a comparative advantage in) and trade with others using the fruits of ones labour to acquire what one needs.

There were a few gaps in his theory that were filled a century later by the neoclassical school which added the discipline of micro economics when looks in more detail at the determinants of price and the exchange of goods and services. This supplemented the Classical school and was not a radical departure from it.

The neoclassical school went unchallenged from then on until the Great Depression hit in the 1930's in the US, an economic depression the like of which has never been seen before or since. A central tenant of the Classical/neoclassical school is that Governments needs to stay out of the way of the market mechanism which is considered to be self-correcting and self-adjusting and it simply was not able to shake the effects of this severe global depression that came as a result of the Wall Street Crash of 1929.

The answer came in the form a British Economist by the name of John Maynard Keynes whose 1936 book entitled “The General Theory of  Employment, Interest and Money” brought a recipe in the form of government intervention to lift the much needed absent demand that was perpetuating the global lull in output and employment. The idea was that when other economic actors (i.e. consumers, firms and exports) are not spending, the government needs to even if this means it goes into debt in the process. The logic being that it can tax the citizens when times are good to pay for it. In short, the government needs to break the deadlock and spend and spend until the economy picks up again.

The remedy of the classical school, which is the power of markets to self-adjust without government meddling, was seemingly proven to be flawed. Wages were not going down to the level needed to allow firms to reduce prices to allow the economic machine to pick up again. A phenomenon the Keynesian's called sticky wages. The invisible hand of the free market was this said to have failed.

It must be stated here that there was an observed inverse relationship between inflation and unemployment which generally held true for the 40 years that Keynes solutions reigned supreme. The relationship observed that when inflation increased, unemployment decreased so one was a price to pay for the other. This relationship was named as the Phillips Curve named after the economist who discovered it.  It was when this relationship broke down that Keynes ideas were thrown out and a new consensus was sought.

In the 1970’s, a new phenomenon was observed where both inflation and unemployment started to rise at the same time and nobody could understand it. The phenomenon was called Stagflation (i.e. stagnation and inflation at the same time).

The saviours this time were the Monetarists, most notably a Chicago School economist by the name of Milton Friedman. He and others such as Robert Lucas put forward a new idea as to explain why the Keynesian medicine was failing to deliver, i.e. why inflation and unemployment were both rising at the same time (an idea we have already called Stagflation).

The idea was called Rational Expectations. Let us briefly consider this.

Expectations are how economic agents think about the future and act in the present. There are a few types but to keep it simple, consider the following types:-

• Adaptive expectations – i.e. the future will be a continuation of  the past
• Rational Expectations – i.e. economic actors will take all available info into consideration to evaluate the future.

What was essentially happening was that people started to factor in the expected future inflation which would occur as a result of the government meddling into their wage expectations and asking for higher wages and this was negating the positive effects of more governments spending.

Therefore the trade-off between inflation and unemployment as depicted by the Philips curve was lost and ineffectual. They were said to have moved from static expectations to rational expectations where they were said to have factored in government interference and pushed for higher wages which put things back to where they were before the government got involved!

The Monetarists medicine was to control the money supply and let unemployment move to its natural rate. He proposed that this was done by raising interest rates a policy which central banks immediately embarked on.  

Milton Friedman’s policy recommendations were so effective in curbing in the massive runaway inflation of the 1970's and bringing the economies back to growth that he won the Nobel Prize as a result and the debate seemed to have been sealed throughout the next 30 years until the global financial crisis of 2008 where the dangers of unfettered free markets was plan for all to see. 

The consensus then settled between the two extremes namely more Keynesian treatment in the form of big role for government spending (aka stimulus spending) as seen under Obama and the British approach of austerity and regulation to both reign in the government and prevent the free market from repeating the same reckless mistakes.

There were other variants of these key approaches, such as the new Keynesian school who incorporated the criticisms of the monetarists and reinvented themselves and the Austrian School but essentially the 2 main approaches set the stage for the 2 extremes within the Capitalist discourse also known as left wing vs right wing or big government vs small government parties that occupy the political economic space in the west.  Put in other words, there are policies that are closer to the Classical School end of the spectrum and those closer to the Keynesian end of the spectrum with all variants in between.

The preceding discussion differentiates the main schools of thought under the hood of Capitalism. The reality of these schools is in the way they diagnose the way markets work and the policies they advocate for when the market fails.

This is different to the discussion of the forms of Capitalism which is a different subject to which we will briefly turn to and conclude with. Capitalism has in parallel to moving through the various theoretical underpinnings as highlighted above, but has also mutated through different forms..

These forms include, but are not limited to the following:-

·     State Capitalism which sees a heavy hand in owning many industries such as the UK before mass privatisation under Thatcher when we had many nationalised industries.

·        Finance Capitalism which subjugates the real economy to the financial sector.

·   Crony Capitalism which involves firms lobbying the governments to bend the rules to favour their interests over the masses.

• Welfare Capitalism (Mixed Economy) or free market capitalism with a safety net to redistribute the fruits of the economy broadly.

Conclusion

The aim of this session has been to try to summarise the last 1000 years of economic thought so we can more able to frame the discourse that is taking place and present the proper solution into the debate.  

Capitalist contributors are in an endless debate between a heavy role for the state on one side and for the state to stand aside and let the market do what it does best when left alone as per the invisible hand rhetoric of Adam Smith. Many have stated that the reason both sides do not reconcile their differences is that the debate is not about the merit of one’s argument but more about the interests that each side represents, another sad fact about the alleged debate which is very seldom mentioned.

To finish, let us bear in mind one simple point in relation to what Islam has to offer. Islam achieves the best of both. It allows the market to work its magic but not at the cost of extreme inequality and market failures as we keep seeing in Capitalism and it does this by using regulation which works as the rules are from the creed and generally adhered to and not always being bypassed as they are in the Western model using financial innovation and elaborate tax evasion schemes.