Economics 1: The key differences between Capitalism and Socialism (v1.0)

A key reference is Professor Edward F Stuart, Ph.D of Northeastern Illinois University. 

Capitalism and socialism are economic systems. Most real systems are neither pure free market capitalism nor full socialism but a mix. Most people in the United States are capitalists. This is especially true for the business community. In recent history, politicians like Bernie Sanders, a staunch democratic socialist, started a movement that has galvanized a big segment of the population. Many progressives today, who arose from that movement, significantly lean towards socialistic or welfare-oriented ideas but still retain many capitalistic principles. The democratic party today is a mix of progressives and moderates (center left) in ideology. The biggest questions today in this debate in US are how should healthcare be managed? How should education be managed? How should the cost of fuel and mass transportation be managed? How should affordable housing be managed? How much regulation is warranted? How much taxation is reasonable for the benefits offered by the system? How big should the safety net be? How much government intervention is necessary to address climate change?

Adam Smith, Karl Marx, Friedrich Engels, John Maynard Keynes, and Milton Friedman were the key thinkers who molded modern economic theories.

Adam Smith (1723 – 1790) wrote “An inquiry into the nature and cause of the wealth of nations” which was published in 1776. The three key things he talked about were the nature of wealth, the necessity of free markets and the benefits of specialization. The most important aspect of a nation’s wealth to him was the total production of goods and services that made the lives of ordinary people better. Today we measure it with gross domestic product measurement which traces its origin to Adam Smith. Adam Smith’s thoughts on how to increase wealth is based on human nature and human motivation. He believed that the greatest motivators were self-love and concern for immediate family and close friends. He also believed most people were social people who liked to interact with society and other human beings. He therefore believed humans have a natural propensity to truck, barter, and exchange. He therefore believed that a commercial enterprise based on market institutions were the best economic system that humans could create and sustain. So, a rational human economy would be based on exchange motivated by self-interest. This economy is guided by an invisible hand – a hand that benefits all parties in the exchange. Smith believed in freedom. People chose their professions based on their interests and skills. If they are good at it, they will succeed and society benefits. Everyone should be free to produce and sell what they want. No group should have a monopoly. He was suspicious of businesspeople getting together and rigging the market. He believed the state should watch and stop anti-competitive behavior. He also recognized the system could breed economic inequality – some would be rich while others would be poor. He therefore believed that it was necessary for the state to provide some minimum standard of living. He felt the best way to prevent too much inequality was promote vigorous competition. Smith saw specialization as the second main source of increased wealth. Each person focuses on what they are good at and trade for everything else they need. By specializing they will figure out how to do their jobs better and faster. It contributes to innovation and progress.

 Karl Marx (1818 – 1883) wrote Das Kapital and the communist manifesto. He first coined the word Capitalism as the economic system based on private property, Markets, and profits. His four key ideas were class society, development of capitalist industry, rise of the working class or proletariat and the inevitability of socialism. In the communist manifesto, he said the history of all societies is a history of class struggle between the oppressor and oppressed. He believed distinct groups in society have conflicting interests. The rich (bourgeoise) would come from property owners, successful merchants, and traders. The working class (proletariats) would come from peasants, non-landowners, and craftsmen and artisans. He believed like Smith that industrialization and the bourgeoise sets the stage for a higher standard of living. Large industries would churn out products cheaply and efficiently and in enormous quantities. His main concern what that the profits went to the owners – not the workers. He believed the workers bargaining power will diminish a lot as more workers compete for fewer jobs thus driving down wages to subsistence levels. It will trend towards more monopoly and fewer and fewer people will dominate the market. He believed the workers only hope was trade unions and collective bargaining. Political parties would arise around these labor unions, and he believed these will eventually be powerful enough to overthrow capitalism and establish social control of industry. This control would be devised to primarily benefit the workers. This is the way inequality would be eliminated. He however left no details on what a real communist economy will look like.  He believed this revolution would occur in highly industrialized and evolved economies like Great Britain. However, a system inspired by it first occurred in poor, unindustrialized, largely illiterate, war-torn Russia instead in 1917 and served as a model for others. The Bolsheviks invented their own economic system, since Marxism did not actually sketch one out, which was based on centralized total control.  As we also know it failed everywhere it was adopted. It always was accompanied with huge corruption and inefficiencies in the central state control apparatus, drift towards oligarchy or authoritarianism, and people losing much of their freedom. However, you still see some of Marx’s ideas in trade unions and labor oriented political parties today even in mostly capitalist societies like UK, US, and Australia. Except for these, Marxism and its soviet variant that came to be known as communism belongs in the dustbin of history. 

Engels (1820 - 1895) worked off Marx’s work. He distinguished between utopian socialism and scientific socialism. To Engels, scientific socialism has a strong Marxist flavor and has an extremely elevated level of state ownership achieved through violent revolution. This is the soviet model and the one most people are familiar with. This is what he pushed, and he dismissed utopian socialism. Utopian socialism was pushed by many social reformers who were often people who had strong religious and moral beliefs who were trying to solve the oppressive and terrible conditions of the working-class workers during the industrial revolution. Utopian socialism was only attempted for a few small communities or organizations – not on a national scale. 

John Maynard Keynes (1883 – 1946) gave birth to macroeconomics and his thinking was shaped by the great depression in the 1920’s. Most governments today practice at least some macroeconomic policies. Governments control taxes and spending levels (fiscal policy) and money supply (monetary policy) to influence economic activity, inflation and unemployment. Government does intervene in the economy. One of his famous quotes is: “Capitalism is the astounding belief that the wickedest of men will do the wickedest of things for the greatest good of everyone.” Franklin Rosevelt was a proponent. 

Milton Friedman (1912 to 2006) was a free market economist. He believed, unlike Keynes, that activist governments create more problems in the economy than they solve. He believed that too much government intervention would damage the balance between demand and supply and the profit motive. It will create inefficiencies and reduce growth. Margret Thatcher and Ronald Reagan were big proponents of Friedman. Two famous statements attributed to Friedman: “There is no such thing as a free lunch” and “If you put the federal government in charge of the Sahara Desert in five years there will be a shortage of sand.”

Socialism falls in a scale ranging from Communism, Marxism, socialism with nationalization of select industries, to social democrat's policies in democracies. 

Update on 4/24/2024: 

Based on the above, three key dimensions emerge. 

1. How is power derived and decisions made? 

    - Democracy

    - Totalitarianism, Authoritarianism, Dictatorship, Oligarchy

2. Who owns the means of production? 

    - Private capitalists (capitalism)

    - The workers (Marxism, cooperatives)

    - The state (Bolsheviks/Leninism Aka Communism)

    - Some by the state (socialism through nationalization of select industries)

3. Which needs of the people is met by the state?

    - Almost all (communism, not really fully clarified by Marxism)

    - Practically none (Friedman/free market capitalism/individual responsibility)

    - Only some through select programs or industry nationalization (socialism)

The question of how well the economy is doing has no simple answer. There are several well accepted measures. The gross domestic product is a measure of all goods and services an economy produces in each period (originally invented by Simon Kuznets for which he received the Nobel prize). The GDP in US is calculated by the bureau of economic analysis. Foreign trade is a growing part of the economy. Exports are part of the GDP. Imports are subtracted from the GDP. GDP per capita is another measure which is GDP divided by persons in population. To account for inflation, we have two measures - current dollar GDP and constant dollar GDP (or real GDP). Combining these, Real per capita GDP is the best measure of the economy. To account for uneven income distribution, measure like the ratio of the top 10% to the bottom 10% incomes, or the median income is used. The Gini coefficient (between 0 and 100 – higher number means more inequality) is also a measure of income inequality. Progressive tax codes also help reduce income inequality. Some societies value avoiding extreme inequality while others value individual freedom and responsibility. Employment statistics are another important measure. Lastly inflation measure includes the consumer price index and the producer price index. There are many other measures into which I won’t go. The world bank publishes many measures for most countries.

The key preconditions for capitalism to flourish are a robust banking system, a robust insurance system, a robust stock market and bond market, private property ownership, private control of the factors of production, competition, use and enforcement of contracts, a robust transportation system, a strong system of laws and courts, and an ample educated labor force. 

Most economies of the world today are mixed economies to various extents. Even China which started as a communist system has adopted many market concepts and is a mixed economy. Communism has resoundingly been relegated to the dustbin of history. What is emerging is an adapted capitalism. Most existing economies today including the US attempts to capture the best aspects of capitalism with some reforms, regulations, controls, and interventions, advocated by the social democrats. Some even go so far as nationalizing certain select industries. This trend to blend first emerged in Europe spearheaded by social democrats. Social Democrats believed that the inequalities of Capitalism could be addressed by reforms to benefit all members of society. They believed that such improvements can be achieved through democratic elections and reforms. They believed some form of planning or state management was essential to reform and sustain the capitalistic system. There were two key motivations. The ethical motives include that allowing poverty and unemployment to exist in society is contrary to ethical values. Prudential motives include that poverty, and unemployment leads to social upheaval and class violence. In a later essay, I will examine key systems in various countries (Sweden, UK, Germany and France) and the blend they have chosen. Each have chosen a different balance. 

The fights today are the extent of the mix between capitalistic policies and social democratic policies or selective nationalization, and the fight between authoritarian forms of government and democracies, and the fight between populism and pluralism. Authoritarians undercut the institutions and rule of law and believe in the absolute power of the executive. In the worst case it is a dictatorship. Authoritarians may be left leaning or right leaning. A flavor of authoritarianism is populist authoritarianism lead by a strong charismatic figure possibly leveraging disinformation and propaganda to deceive and mislead.