The Road to Prosperity: Saving Capitalism from Capitalists
by Raghuram G. Rajan and Luigi Zingale

The corrupt version of capitalism—when powerful corporations deliberately try to eliminate healthy competition to preserve their privileged position—generates economic inefficiencies and social injustice, thereby undermining political support for the free-market-based system; however, an ownership structure that is too dispersed is just as ineffective and dangerous. When ownership is correctly distributed, given the right dose of regulations and the alleviation of social costs, a political consensus in favor of markets can be achieved.

As far as most Americans are concerned, capitalism is part of the American landscape. Its emergence was as spontaneous as the grass growing in their endless prairies, and like the prairies the only risk it faces is too much human intervention. According to them, no intervention is the best policy.

Capitalism: Taking It for Granted?

As the American experience has dominated economic thinking, economists tend to be overconfident about exporting capitalism to other countries. Some think that exporting American law and institutions is sufficient to make capitalism blossom instantaneously. It worked for the United States, why shouldn’t it work for other countries? For this reason, economics has typically been oblivious to the political preconditions for the development of capitalism. The fall of the Berlin Wall and the massive experiments with transition economies, however, provided a rude awakening. The experience of the last decade shows that in order to work, capitalism needs more than a good set of laws and institutions. Above all, it needs political consensus among the people. Without political consensus free markets cannot survive.

Once economists recognize this simple truth, then the current American optimism about spreading capitalism seems excessive. Indeed, it is substituted by a moderate pessimism about the intrinsic fragility of capitalism, not its economic fragility (as Marx theorized), but its political fragility. In a nutshell, the idea is as follows. While everyone benefits from competitive markets, no one in particular makes huge profits from keeping the system competitive and the playing field level. Thus nobody has a strong vested interest in promoting and defending free markets. Free markets are a public good, and like all public goods, have no natural constituency.

On the contrary, competitive free markets have many enemies. Not only do their ranks include distressed workers who have lost their jobs because of competitive pressures, but also large industrialists themselves. Truly free markets create competition, which undermines the position of established firms, forcing them to prove their competence again and again. Hence a truly capitalist system not only finds that generating political support is difficult, it also often encounters explicit opposition among the most influential groups. It should thus come as no surprise that true free market capitalism takes root with great difficulty, which is why it is so difficult to export.

After the 1994 Mexican crisis, for instance, the World Bank decided to help the government improve the financial infrastructure. One of the fundamental institutions that was missing was a credit registry, where assets posted as collateral for a loan could be officially recorded so that any potential lenders could be aware of what a borrower had already pledged. In setting up this registry, the World Bank experienced strong resistance from the banks. The banks already had enough clout and local experience that they could get this information regardless of any credit registry. Not only would they not benefit from it, but they would see their competitive position eroded as less established lenders could access that information and compete for business on an equal footing. Thus access to credit was curtailed to support the interests of the few.

This is not an isolated case, and similar examples abound, even in the industrial countries. Worldwide large and established firms and financial institutions have the greatest influence on policy, including the setting up of market infrastructure. Often they are simply not interested in expanding access to everyone, because that would increase competition. No wonder that the interests of free markets are not well served and that the poor around the world see markets as being against them, not realizing that what they are experiencing is a corrupted version of what capitalism should and could be.

Not only does this corrupt version of capitalism generate economic inefficiencies and social injustice, it also undermines the political consensus for a truly free market system. In the early 1990s, Robert Shiller documented that Russians had attitudes toward private property and markets that were very similar to those of Americans, but a recent survey finds that 72 percent of Russians would like to see privatized property returned to the state. Ten years of corrupt capitalism have undermined the consensus in favor of free markets even more than seven decades of communist propaganda did.

Why then did capitalism emerge spontaneously in the United States—and before that in England—but is so difficult to establish in other countries? What lessons can we extract from history on what works—and what does not work—in promoting capitalism? Our book, Saving Capitalism from the Capitalists, tries to answer these crucial questions.

Right Dose of Government

For capitalism to emerge and function a country needs neither too little nor too much government. To understand why, consider the following example. If you wanted to fly somewhere and the airline industry lacked any overall supervisory authority and no regulations were in place enforcing safety standards, you would be extremely reluctant to fly fledgling airlines. You would prefer the established ones that had a good track record and reputation. Thus a complete lack of safety regulations in the airline industry would favor established firms, making entry impossible and killing competition. By contrast, if the regulations were such that airlines had to have a proven five-year track record of profitable flying before they were allowed to fly passengers, new entry would again be killed off, for how could new entrants have a proven record? Competition flourishes in the delicate middle ground.

A country can only achieve this balance when there is broad consensus in favor of markets, and such consensus arises only with the right distribution of ownership. Too much ownership concentration is inimical to market development, because large owners can protect their interests without a fair and objective judicial system, and so they have no interest in developing one. Indeed, they often have an interest in preventing its development so they can continue their privileged violations unimpeded. But too dispersed an ownership structure is not conducive to capitalism either, because it makes coordinating a strong pro-market movement more difficult.

England achieved this delicate balance in the 16th century following the expropriation of large landowners and the widespread sale of land that took place under Henry VII and Henry VIII. This created a powerful gentry, who were neither too powerful individually to dispense with the law nor too weak collectively to demand its enforcement and to withstand the monarch’s depredations. Not only did the United States import this economic structure from England, it actively promoted it. Americans like William Penn and Thomas Jefferson were deeply influenced by the British philosopher James Harrington, who in his 1656 book, Oceana, argued in favor of a more equal distribution of land ownership, which he saw as the key to England’s success.

Paradoxically, a country can achieve this balance of power more easily when it lacks natural resources. Natural resources such as oil and diamonds create an automatic concentration of economic, and hence of political, power that is difficult to undo, especially during the early phases of development when no offsetting sources of power exist. In the absence of natural resources the government has no choice. If it wants to be able to raise some revenues, it has to promote commerce and trade, and to do so it has to restrain itself and establish a reliable system of law. But when it controls a lot of easily extracted natural resources, the government can fund itself without the people’s consent and can therefore afford to be despotic. It is no coincidence that in modern times more democratic forms of government were first established in Venice and the Netherlands, where the prime economic resource was people’s industriousness, and it is no coincidence that even today, countries rich in natural resources have some of the most despotic regimes.

Privatizing natural resources is not a panacea either. Given the economic, and therefore the political, power these resources provide, the necessary separation between the government and the resource owners becomes infeasible. Either the owners acquire so much political power that they run the country in practice, or the government eventually succumbs to the temptation of re-appropriating the resources. Either way, a reliable system of law and property rights cannot be established.

By contrast, a country can more readily achieve the balance between too much and too little government when it is open to foreign competition. While local lobbies can hamper local competitors, they have no power against foreign ones, other than by closing the country’s borders. When the widespread openness of world trade or the pressure from bordering nations makes this latter option infeasible, markets flourish.

Implications for Transition Countries

While we did not write our book only with transition economies in mind, it does have several implications for them.

• It explains why Azerbaijan, Kazakhstan, and Russia, which are rich in natural resources, have found the path to a market democracy more difficult to follow than the Eastern European countries, which are not as awash in natural resources.

• It points to why voucher privatizations were a mistake. In the attempt to build an extremely fragmented ownership structure, more fragmented than that in any Western country, they undermined the possibility that political demand for legal protection would emerge. The ironic result was an excessive concentration of ownership, when the few who were well connected and well informed were able to scoop up the shares that citizens unable to get any value for their claims dumped on the market. In Russia the problem was only made worse by the loans-for-shares agreement, whereby the most valuable natural resource companies were given away to the politically well connected.

• It suggests that the hopes of a rapid move to a free-market democracy in Russia may be overly optimistic. These hopes are based on the idea that the process of consolidation of ownership in the Russian oil and gas industry has created some powerful players who virtually own their firms, and therefore have an enormous stake in promoting the good of the country. This idea is not new. In the 1950s Charles Wilson, president of General Motors (GM) and later secretary of defense under President Eisenhower, stated: "What’s good for GM is good for the country." This was not true for the United States back then, and it is not going to be true for Russia today. On the contrary, the extreme concentration of ownership in Russian natural resources spells trouble for the future.

What we are witnessing now is a battle between the oligarchs and the state over who will control the huge profits generated by natural resource extraction. On the one hand, President Putin is trying to raise revenues (and potentially quell political dissent) by threatening the oligarchs with the specter of government expropriation, legitimized by the illegality of the privatization process. On the other hand, the oligarchs are trying, literally, to buy consensus among the legislators to ensure that their will becomes law. Either outcome, however, will be bad for free markets and democracy. If the oligarchs win, their property will become more secure, but competition and free entry will not be promoted. More important, they will undermine the credibility of the new fragile democracy. If voters, who deeply resent the privatization process, see their will overturned by a servile parliament, what future will democracy have in Russia? But if the government succeeds in expropriating the oligarchs, what future will private property, and therefore a market economy, have in the country?

Betting Against the Odds

What can be done? In our book we pin our hopes on market openness and a set of structural reforms to promote wider and more efficient distribution of ownership. We also argue that alleviating the social costs that markets generate is important so as to reduce antimarket sentiment. This is unfortunately widespread in countries like Russia, where the introduction of a market system has brought unemployment, and often poverty, to large segments of the population. We are well aware, however, that our policy recommendations contain a potential contradiction. If the oligarchs are so influential in politics, what hope do we have that any policy aimed at reducing their long-term power will be implemented?

The missing piece, the source of hope, is to create widespread political awareness that will sustain reform. While we are realistic about the power of money, we are not so disillusioned as to believe that ideas have no power. Indeed, our aim in writing Saving Capitalism from the Capitalists was to help create awareness that capitalism is not broken, but that in much of the world it just needs to be saved from the capitalists.

Raghuram Rajan and Luigi Zingales are professors at the University of Chicago. (Mr. Rajan succeeded Kenneth Rogoff as chief economist of the IMF in October 2003, their book, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, was published in February 2003 by Crown. j