Book Summary: “Good Capitalism, Bad Capitalism” by Baumol, Litan and Schramm

Title: Good Capitalism, Bad Capitalism and the Economics of Growth and Prosperity
Author: William Baumol, Robert Litan and Carl Schramm
Scope: 3.5 stars
Readability: 3 stars
My personal rating: 5 stars
See more on my book rating system.

If you enjoy this summary, please support the author by buying the book.

Topic of Book

The authors argue that there are multiple types of capitalism and entrepreneurialism is key to economic growth.

If you would like to learn more about long-term economic growth, read my book From Poverty to Progress: How Humans Invented Progress, and How We Can Keep It Going.

Key Take-aways

  • While most people think of capitalism as one type of economy, there are four different types of capitalism:
    • State-guided capitalism, in which government tries to guide the market, most often by supporting particular industries that it expects to become “winners”; These nations include China, India and other Southeast Asian nations.
    • Oligarchic capitalism, in which the bulk of the power and wealth is held by a small group of individuals and families; This type dominates in Russia, Latin America, Africa and the Middle East.
    • Big-firm capitalism, in which the most significant economic activities are carried out by established giant enterprises; this type dominates in Europe, Korea, Japan and portions of the US economy.
    • Entrepreneurial capitalism, in which a significant role is played by small, innovative firms. This type is only widespread in the US and Taiwan.
  • To be successful an economy needs a blend of established large corporations who perfect and mass produce existing technologies along with small companies who innovate new technologies.
  • What is missing from most capitalist economies is entrepreneurial capitalism. Those nations should gradually introduce reforms that make it easy for small companies to incorporate and scale up.
  • The closer a nation is to the technological frontier, the more important it is to have entrepreneurial capitalism as copying others becomes less viable.
  • To encourage the growth of entrepreneurial capitalism, a nation must:
    • Lower the costs of “formality” (business and property registration and ease of hiring and firing workers)
    • Have a workable bankruptcy system in place
    • Facilitate the formation and growth of their formal financial sectors, which channel resources to innovative entrepreneurs

Important Quotes from Book

Many books take off from one core idea. This book is built on two.

The first notion is that capitalism is not a monolithic form of economic organization but rather that it takes many forms, which differ substantially in terms of their implications for economic growth and elimination of poverty.

At its core, this book is about these four different types of capitalism— entrepreneurial, big-firm, state-directed, and oligarchic—and how they affect growth.

But as one of us (Baumol) elaborated over a decade ago, it takes a mix of innovative firms and established larger enterprises to make an economy really tick. A small set of entrepreneurs may come up with the “next big things,” but few if any of them would be brought to market unless the new products, services, or methods of production were refined to the point where they could be sold in the marketplace at prices such that large numbers of people or firms could buy them. It is that key insight that led us to the conclusion that the best form of “good capitalism” is a blend of “entrepreneurial” and “big-firm” capitalism, although the precise mix will vary from country to country.

The most astonishing thing about the extraordinary outpouring of growth and innovation that the United States and other economies have achieved over the past two centuries is that it does not astonish us.

The current most critical long-term economic issue for the world is how this performance can be sustained in the wealthiest countries and how it can be transplanted to societies where much of the population lives in abject poverty. To find an answer to these questions, it is necessary to investigate what is different about the economies that have already achieved this spectacular success.

Our four elements of a well-oiled economic growth machine, the successful entrepreneurial economy, are the following:

1. First, and perhaps quite obviously, in the successful entrepreneurial economy, it must be relatively easy to form a business, without expensive and time-consuming bureaucratic red tape. As a corollary, abandoning a failed business (that is, declaring bankruptcy) must also not be too difficult because, otherwise, some would-be entrepreneurs may be deterred from starting in the first place. A reasonably well-functioning financial system must also exist, one that channels the funds of savers to the users of funds, entrepreneurs in particular. And the importance of flexible labor markets cannot be overstated: if entrepreneurs cannot attract new labor, they cannot grow, nor will they want to grow if labor rules are overly restrictive (especially if rules limit the ability of firms to fire nonperforming workers or shed workers they no longer need).

2. Second, institutions must reward socially useful entrepreneurial activity once started; otherwise individuals cannot be expected to take the risks of losing their money and their time in ill-fated ventures. Here, the rule of law—property and contract rights in particular—is especially important.

3. Third, government institutions must discourage activity that aims to divide up the economic pie rather than increase its size. Such socially unproductive (though, in a sense, entrepreneurial) activities include criminal behavior (selling of illegal drugs, for example) as well lawful “rent-seeking” behavior (i.e., political lobbying or the filing of frivolous lawsuits designed to transfer wealth from one pocket to another).

4. Finally, in the successful entrepreneurial economy, government institutions must ensure that the winning entrepreneurs and the larger established companies (which were launched at some earlier time by entrepreneurs) continue to have incentives to innovate and grow, or else economies will sink into stagnation. The ostensible importance of effective antitrust laws here comes to mind, but we place greater emphasis on openness to trade (which works automatically and without the long lead times inherent in legal antitrust enforcement).

Rather, we will classify the economies of the different capitalist countries in four categories:

1. state-guided capitalism, in which government tries to guide the market, most often by supporting particular industries that it expects to become “winners”;

2. oligarchic capitalism, in which the bulk of the power and wealth is held by a small group of individuals and families;

3. big-firm capitalism, in which the most significant economic activities are carried out by established giant enterprises; and

4. entrepreneurial capitalism, in which a significant role is played by small, innovative firms.1

About the only thing these systems have in common is that they recognize the right of private ownership of property; beyond that they are very different. In particular, the economies in one category tend to have growth records very different from those in another, and that is because their mechanisms of growth, innovation, and entrepreneurship vary substantially. We will maintain that one of the most promising ways to promote growth in an economy that is currently characterized by a slow-moving form of capitalism is to adopt reforms that move it toward a type of capitalism with a more powerful growth engine. For the same reason, economies that already are characterized by a fast-growing form of capitalism must vigilantly watch out for developments that might undermine their membership in that group.

State-guided capitalism exists where governments, not private investors, decide which industries and even which individual firms should grow. Government economic policy is then geared to carry out those decisions, using various policy instruments to help out the chosen “winners.” The overall economic system nonetheless remains capitalist because, with the exceptions to be discussed shortly, the state recognizes and enforces the rights of property and contract, markets guide the prices of the goods and services produced and the wages of workers employed, and at least some small-scale activities remain in private hands.. Under state-guided capitalism governments typically take the position that centrally planned direction of or influence on the allocation of resources in the economy is the best way to maximize economic growth. Governments have a number of means at their disposal to guide growth. Perhaps the most important is explicit or implicit ownership of banks, which are the principal conduits in virtually all countries for transferring the resources of those who save to those who invest the savings. Only in the United States, at least so far, is this task of transmission of financial resources from savers to producers carried out primarily in organized capital markets, such as stock and bond markets, rather than by banks.

It also may be tempting to equate state-driven capitalism with central planning, but the two systems also are very different. In centrally planned economies, the state not only picks winners, it also owns the means of production, sets all prices and wages, often cares little about what consumers may want, and thus provides essentially no incentive for innovation that benefits the individual.

In sum, states can often successfully guide their economies when they have well-defined targets to aim for. But as economies catch up to the technological frontier, the low-hanging fruit will have been picked. At this point, or perhaps well before it, the drawbacks of state-guided capitalism become more evident: excessive investment, an inability to come up with radical innovation, susceptibility to corruption, and the reluctance to channel resources from low-yielding activities toward potentially more rewarding ventures become the norm.

Capitalism is defined as “oligarchic” when, even though the economic system is nominally capitalist and property rights protect those who own substantial property, government policies are designed predominantly or exclusively to promote the interests of a very narrow (usually very wealthy) portion of the population or, what may be worse, the interests of the ruling autocrat and his (or her) friends and family (in this instance, the system is better characterized as a “kleptocracy”). This form of capitalism is, unfortunately, all too common in too many parts of the world, encompassing perhaps one billion or more of the world’s population. It is prevalent in much of Latin America, in many states of the former Soviet Union, in most of the Arabic Middle East, and in much of Africa.

In these societies, economic growth is not a central objective of the government, whose main goal is instead to maintain and enhance the economic position of the oligarchic few (including government leaders themselves) who own most of the country’s resources.

Oligarchic capitalistic economies generally have several features in common. First, and perhaps most obviously, their incomes are distributed extremely unequally (and their wealth tends to be distributed even more unevenly).

Latin American economies, among other developing-country economies, have been plagued by a second feature associated with many if not most oligarchic economies: a high share of “informal activity.”

Oligarchic economies typically are plagued by corruption, even more than in state-guided capitalism, though corruption certainly is not unknown in any economic system. Governments that make it difficult for citizens to obtain licenses or approvals—the preconditions that lead to informality—also create opportunities for lesser officials to take bribes. Indeed, firms that pay bribes typically face more intrusion from government officials than law-abiding enterprises.

Finally, there are some oligarchic countries where abundance of a natural resource—oil, in particular—helps cement that form of capitalism and makes it difficult to dislodge.

Both Schumpeter and Galbraith concerned themselves with what we call big-firm capitalism, in other words, economic systems dominated by large companies, where the original founder of the company either has passed from the scene or is no longer in effective control of the company. Ownership of such enterprises is widely dispersed among many shareholders, often including some large institutional investors (insurance companies, pension funds, universities, foundations, and the like). Professional managers are the “agents” of these “principals,” giving rise to the wellknown “principal-agent” problem, that of ensuring that the managers continually act in the best interests of the owners of the firms they manage.

We identify big-firm capitalism primarily with Continental Europe, Japan, Korea, and pockets of other economies, including the United States.

Often, but not always, big-firm capitalism is oligopolistic. That is, it is characterized by large firms operating in markets that, because of their limited size, are capable of supporting only a few competitors who may be able to take advantage of any significant economies of scale provided by the current technology. Or these markets may contain only one or a few firms because of “network effects,” where the value of a good or service depends on how many others use it.

But big firms nonetheless can grow and prosper by constantly refining existing products and services and occasionally developing new ones, typically after considerable market research about what consumers will and won’t buy. The innovation process becomes routine and predictable, picking up “three yards at a time” (to use an American football analogy) rather than seeking the breakaway touchdown. Such constant, albeit routine, refinement is necessary in any economy.

Indeed, big firms are also essential to mass-produce some of the innovations that radical entrepreneurs are unable by themselves to manufacture in a cost-effective way.

The more typical pattern among larger firms, however, is one that is the Achilles’ heel of big-firm capitalism itself: the tendency not to innovate.

The sclerosis of larger firms threatens the growth of entire economies not only because of missed opportunities but because it can infect the attitudes of those who work for them. The labor market counterpart of a stagnant product market is when workers see job security, rather than personal growth and contribution to their company’s welfare, as their highest priority. It is not an accident that in the leading exemplars of big-firm capitalism— continental Europe and Japan—labor markets are rigid, employment security is taken for granted, and firing is rare.

In short, big-firm capitalism at its best generates sufficiently large cash flows to finance internally the continuing, incremental improvements in products and services that are staples of any modern economy. At its worst, big-firm capitalism can be sclerotic, reluctant to innovate, and resistant to change.

Entrepreneurial capitalism, the capitalist system in which large numbers of the actors within the economy not only have an unceasing drive and incentive to innovate but also undertake and commercialize radical or breakthrough innovations. These innovations are bolder than the incremental innovations that characterize big-firm capitalism. Together, these innovations, as improved and refined by the entrepreneurs themselves or by other existing firms, have improved living standards beyond anything our ancestors could have believed.

But where do these radical, breakthrough innovations come from? The answer is that transformational technologies, and hence entrepreneurial capitalism, would not exist without entrepreneurs, who recognize an opportunity to sell some thing or service that hadn’t been there before and then act on it. Radical breakthroughs tend to be disproportionately developed and brought to market by a single individual or new firm, although frequently, if not generally, the ideas behind the breakthroughs originate in larger firms (or universities) that, because of their bureaucratic structures, do not exploit them.

One of us (Baumol) has offered several reasons why radical innovations seem to emanate from entrepreneurs rather than large firms (at the same time being careful to note that most entrepreneurs are replicative rather than radical).15 For one thing, successful radical innovation, if undertaken by the entrepreneur, promises what might be called “mega-prizes”—hundreds of millions, if not billions, of dollars of wealth. Nothing comparable awaits the radical innovator in a large firm, who might get a special recognition award and a onetime bonus.

To summarize, entrepreneurial capitalism is the system we believe is most conducive to radical innovation. But no advanced economy can survive only with entrepreneurs (just as individuals cannot survive by eating just one type of food). Big firms remain essential to refine and mass-produce the radical innovations that entrepreneurs have a greater propensity to develop or introduce.

The blend of big-firm and entrepreneurial capitalism we extoll here may not be right for all economies at all times. It may be that in their initial stages, economies need or benefit more from the guiding hand of the state, or so some have argued. We will not enter that debate here. We are surer, however, that once economies approach the technological frontier—that is, once their living standards are among the highest in the world—they can remain at or become the frontier only by shedding state guidance and adopting some blend of entrepreneurial and big-firm capitalism. The nature of this blend, as well as the characteristics of entrepreneurial capitalism in particular, will differ from country to country, depending on historical circumstances and differences in culture. Simply put, all economies need some degree of entrepreneurship to generate radical innovation, yet they also need effective big firms to refine it and commercialize it on a mass scale.

An entrepreneurial economy must have entrepreneurs—not just any entrepreneurs, but innovative entrepreneurs. We submit that three preconditions are necessary to generate them. To encourage the formation of innovative entrepreneurial enterprises, governments should lower the costs of “formality” (business and property registration and ease of hiring and firing workers); have a workable bankruptcy system in place; and facilitate the formation and growth of their formal financial sectors, which channel resources to innovative entrepreneurs.

It is not sufficient for entrepreneurial economies to make it easy for entrepreneurs to start their businesses. Such individuals and the firms they found must be rewarded for their success. Several institutions are important are in this regard: the rule of law (effectively enforced), intellectual property protection (but not too much), taxes that are not unduly onerous, and rewards and mechanisms to facilitate imitation in certain environments.

Technological breakthroughs happen only when related ideas or products, already in the marketplace, are put together in new ways (Hargadon, 2003). Successful innovative entrepreneurs are the ones who recognize and then realize the commercial opportunities that such recombinations offer.

Historically, the more important benefits from innovation are the localized networks that it can help create. Firms in industries tend to cluster in certain locations. In the United States: high-tech in Silicon Valley, autos in Detroit, furniture in North Carolina, entertainment in Los Angeles, securities and banking firms in New York, insurance companies in Hartford.

First, regardless of the state of their economic development, all less developed countries can benefit by promoting entrepreneurship, of both kinds we have so far outlined: replicative, in the sense that technology should be borrowed from abroad, typically by accepting foreign direct investment; and innovative, through so-called bottom-of-the-pyramid product and service innovations adapted to the unique circumstances of individual developing economies (and for countries at later stages of development, through adaptation of cutting-edge products and services currently designed for rich country markets, firms, and consumers).

Second, it is unrealistic to expect the more successful state-guided developing economies, including the former developing countries that used state guidance to approach living standards of the industrialized world, suddenly to embrace all the principles of entrepreneurial capitalism outlined in the last chapter. Nonetheless, there are opportunities for these economies to introduce these policies at the margin, or incrementally, in fashions we discuss here.

First, the evidence does not support the view that detailed economic guidance by the state—that is, directing aid or providing appropriate approvals to some sectors and firms and not others—adds to growth, above and beyond what can and has been generated by high domestic savings and generally sound government policies that support growth (such as the provision of universal education, prudent macroeconomic policies, and protection of rights of property and contract) without attempting to “pick winners.”

Second, since the World Bank’s landmark study, the growth experience of India, in particular, provides strong evidence that state guidance can be more of a hindrance than a stimulant to growth and that random or accidental events—so often characteristic of entrepreneurial success stories— can fuel the expansion of a world-class entrepreneurial sector and, in turn, advance growth of the entire economy.

For almost every type of economic activity—not just opening a business, but buying and installing a rudimentary piece of equipment—some sort of government approval was required. Information technology (IT) related fields, such as software coding and development and later international call-center operations, were an accidental exception to this pattern, and in retrospect many Indians surely must be thankful that they were.

For example, in the 1950s and 1960s India’s leaders wanted to produce more home-grown scientific and engineering talent, and they did so by establishing and supporting what eventually became some of the world’s finest schools of engineering, now turning out tens of thousands of highly trained Indian engineers a year.

Taiwan’s postwar success also illustrates how a broader trust in entrepreneurship paved the way for that country’s remarkable growth record after the Chinese civil war of the late 1940s. Taiwanese leaders recognized the need for growth but did not attempt to pick specific industries or firms to promote. Instead, they took the view that the best way for the government to assist growth would be to promote the growth of firms in export industries, through financing, tax incentives, and an exchange rate policy (carried out by central bank purchases of the U.S. dollar) that has kept the Taiwanese dollar undervalued relative to foreign currencies. The government also made it relatively easy for new firms to start and grow, and it subsidized the education of its talented students to study abroad, principally in the United States.

Even mainland China’s rise to economic power during the past two decades does not support the view that detailed state guidance is necessary for economic success.

Whether by design or by necessity, Beijing has decentralized economic and political decision-making to the provincial and municipal governments, which in turn have used their expanded freedom to engage in productive ventures as well as to grant licenses, incentives, and other favors to certain local privately owned “champions” (which are often purchased with “side-payments,” or less politely, bribes).

The Chinese model may be a unique case, however, since other developing countries (with the outlying exceptions of Cuba and North Korea) do not have a legacy of central planning. In addition, China has advanced despite not fully having two of the ingredients for a successful entrepreneurial economy that we highlighted in chapter 5: effectively enforced property and contract rights, and a financial system that affords entrepreneurs access to capital to finance their ventures. The Chinese legal system is still a work in process, to put it charitably.

China owes much of its economic success to the welcome mat its leaders have put out to foreign investors.

One of the amazing things about China’s success in this regard is that foreign investors have continued to rush into China, although legal protections for contracts and property, and the courts that support them, are far from ideal, and corruption reportedly is pervasive.

Somewhat ironically, poor countries that want to emulate China’s success in attracting foreign direct investment will have to take measures that, as a by-product, should foster domestic entrepreneurship in their own countries. Foreign direct investment has long been very unevenly distributed around the world, being concentrated in rich countries and in only a selected handful of developing or emerging market economies. For developing countries that have not been prime destinations for foreign investment to have any chance at cracking into this select circle of destination countries, their governments will have to take steps to make foreign investors feel welcome. At the top of this list are such essentials as enforceable rights of contract and property and a minimum of corruption. Having a suitable supply of trained labor, made possible by widespread primary and secondary education, also is necessary. As it turns out, these elements are also essential to promoting domestic entrepreneurship..

In short, the examples of India, China, and Taiwan provide striking evidence supporting the World Bank’s finding that state guidance is not the silver bullet for accelerating economic growth that some of its advocates may believe. Rather, economies grow because individuals and the firms they form are the engines that turn labor, capital, and technology into products and services that consumers, inside countries and beyond, want and are willing to pay for. Firms, in turn, just don’t appear from nowhere. They are started and nurtured by entrepreneurs, who take on often seemingly unimaginable risks. Countries that want to grow cannot overlook this simple but powerful fact.

Our suggestion is some form of incremental change, or entrepreneurial capitalism at the margin. The notion is to encourage entrepreneurship while not necessarily dismantling the part of the economy that is dependent on state guidance.

Continental Europe and Japan, as perhaps the leading exemplars of big-firm capitalism, need a healthy dose of what we have called “innovative entrepreneurship.” Although some large firms in these parts of the world have been truly innovative—Toyota in Japan or Nokia in Europe, to take two examples—the United States experience teaches that the most reliable source of radical innovation (and that is what is required to step up growth) is to be found among new, vibrant firms that do not have a vested interest in preserving their current markets.

Both Europe (including Great Britain) and Japan moved away from their entrepreneurial roots toward a very different sort of capitalism, one that focused on not only preserving large firms, but also actively promoting them through various forms of state guidance: subsidies, implicit or explicit directions to banks to support particular enterprises, and other kinds of state assistance.

For one thing, there was no populist revolt—as there was in the United States, in the form of antitrust legislation—in either Europe or Japan against the emergence of large firms that may have dominated particular markets.

Second, the financial systems in both Japan and Europe were especially conducive to the emergence and growth of big-firm capitalism. In both economies, banks have long been the dominant source of financing for business, and not just any banks—very large banks. Indeed, in Japan, following World War II, certain “main banks” developed in and around Tokyo, and government (through the Ministry of Finance) fostered their growth.

The Japanese and European financial systems heavily favored well-established companies rather than start-ups or fledgling enterprises for two reasons. Banks naturally were more interested in lending to larger companies whose shares they had bought and could potentially trade. At the same time, securities markets developed more slowly in Japan and Europe than in the United States.

[After World War II] Because they literally were starting over, firms in both economies were well positioned after the war to do little more than imitate or adopt American technology, either through licensing, joint ventures, or simply basic observation. And that is exactly what they did until a number of the more successful enterprises introduced incremental and in some cases radical innovations that outpaced their American counterparts.

Yet what happens when one runs out of things to imitate? That is essentially the problem that confronted both Europe and Japan at the end of the twentieth century.

One of the most immediate perils facing the U.S. economy is the possibility of transforming into a much less entrepreneurial big-firm regime, one characterized by ossification, limited incentives, and a paucity of breakthrough inventions. There is no simple formula for preventing such an outcome, but the analysis of this book suggests the importance of two key principles: provide incentives for productive entrepreneurship and discourage diversion of entrepreneurial talent into unproductive or destructive sources of wealth.

For all these reasons, it will be critical for the United States to maintain and, ideally, improve upon the institutions that satisfy the four preconditions outlined for ensuring the right blend of entrepreneurial and big-firm capitalism. Here, and in the rest of this chapter, it will be convenient to combine the four preconditions into three:

1. Adequate incentives for productive entrepreneurship, including appropriate rewards and adequate security of those rewards and of the earnings processes, must be maintained and ideally strengthened;

2. Disincentives for unproductive entrepreneurship must be restricted and ideally eliminated; and

3. Continued rivalry among and innovation by large firms must be ensured.

Our reading of the historical evidence and the experiences of prosperous, innovative, and rapidly growing economies suggests the central importance of two conclusions for all who want their economies to be as successful as they can be in delivering rising living standards to their peoples. First, incentives really matter. Countries where activities that promote growth are rewarded will grow faster than countries where this is not the case. Second, the contribution of the entrepreneur in the growth process is substantial.

If you would like to learn more about long-term economic growth, read my book From Poverty to Progress: How Humans Invented Progress, and How We Can Keep It Going.

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