We don’t have to choose between capitalism and socialism. What we need is a system in which corporations can thrive without distorting the economy — or democracy itself.
One of government’s fundamental roles is to enable markets and protect stakeholders when the forces of capitalism fail to do so. | iStock/Bill Oxford
The debates about our economic system are sometimes framed as a stark choice between market-based capitalism and government-controlled socialism. But the actual choices are much more complicated.
Corporations, which control much of our economic activity today, owe their existence to governments. Although they do not vote in elections, the economic and political power of corporations and their impact on democracy are immense. The challenge arises from the tension between functioning democracy on one hand and narrowly defined business practices on the other hand. For the market economy to serve society in a democracy, more citizens must become educated about the forces that shape the system, including corporations and governments, and the key role of effective governance in determining the outcomes.
In his famous 1970 essay “The Social Responsibility of Business Is to Increase Its Profits,” Milton Friedman championed “free-market capitalism” where managers should “make as much money as possible while conforming to the rules of society.” He presumed that businesses operate in an environment of “open and free competition without deception and fraud,” but he failed to discuss whether or under what conditions this assumption is true. In fact, markets are unlikely to become competitive and devoid of deception and fraud on their own, and capitalism cannot deliver on its promise without effective governments.
Friedman warned against “the iron fist of government bureaucrats” that the concerns of chief executives about corporate social responsibility would bring back. But a key role of government is to enable markets and to protect stakeholders when market forces fail to do so properly. The civil servants (“bureaucrats”) whom Friedman mentioned derisively are essential for enforcing contracts, ensuring competition, administrating justice, protecting rights, and dealing with fraud and deception when conventions, accepted business practices, or cultural norms fail to hold actors accountable to socially acceptable behavior. Governments also maintain infrastructure and provide important services, including public safety, benefits that many ignore or take for granted. If governments fail to design and enforce appropriate laws for individuals, businesses, and markets, then it no longer follows that managers who solely focus on making as much money as possible are fulfilling their social responsibility.
The critical issues lie not in the size of government, but rather in the quality, integrity, and effectiveness of the individuals and institutions that act on its behalf. To fully realize the benefits of democracy, political systems and government institutions must embody the collective choices of all citizens, and the rules of the game must be designed and enforced to serve the social good.
Diagnosing Underlying Causes
These days, well-functioning democracies are few and far between. Democracy itself appears to be in retreat around the world, and trust in private and government institutions, particularly in the United States, is low. In a 2018 poll conducted by Harvard University’s Institute of Politics, nearly two-thirds of Americans ages 18–29 expressed fear for the future of democracy in America, and in a 2018 Gallup Poll, only 25 percent of Americans expressed “a lot” or “a great deal” of confidence in big business. Public trust in the U.S. government seems to be at a near historical low. Unfocused anger with “the system” can be misdirected by demagogues and lead us away from the right solutions. To tackle effectively the lack of trust and the distortions in our prevailing economic system and in our democracy, we must first diagnose their underlying causes.
The problems plaguing democracy and capitalism are largely rooted in the complex interactions between corporations, governments, and individuals. These interactions are fraught with conflicts of interest, wide gaps in information and expertise, and the potential for abuse of power. Effective governance is key. How do we ensure transparency to hold the powerful accountable in the private and public sectors? How do we prevent conflicted experts and narrow interests from having excessive impact, particularly on issues that appear complex and confusing to nonexperts and the public? Ultimately, how can we trust those with power in corporations and in government institutions who have important impact over our lives to avoid abusing their power and causing harm?
Corporations and governments have numerous points of contact. Some interactions are primarily transactional: when corporations sell goods and services to government bodies, including essential services such as prisons, security forces, transportation, weapons, health care, and medicines, for example. Some corporations act as private watchdogs, providing credit ratings and financial audits to private and government entities. Financial institutions are involved in funding governments as investors and intermediaries. Consultants offer advice to governments as well as to corporations. Media corporations inform the public about government bodies as well as on private sector corporations. In all these engagements, conflicts of interests and information gaps create numerous opportunities for abuse of entrusted power. Corruption can occur even if nobody breaks laws.
Particularly insidious challenges to democracy arise when corporations become involved in the writing of the rules that apply to everyone, including themselves, or interfere with enforcement. The problem is not new, but it has been exacerbated with increases in corporate lobbying activity. Over their history, U.S. corporations have used the legal system to gain many legal rights and fight against government rules. Some of the legal rights of corporations are important to their ability to benefit society; others, however, such as political speech and religious rights, aren’t directly linked to any social benefits. Yet, the 2010 decision by the U.S. Supreme Court in the case Citizens United v. Federal Election Commission allows corporations to spend unlimited amounts of money on campaign contributions and political activity.
Democracy Undermined
When corporate engagement with governments serves narrow interests and money is critical for campaigns and influence, the system causes “corruptive dependencies,” exacerbates inequality, and leads to the perception that our “captured economy” is rigged and unjust. Corporations can also pit governments in different jurisdictions against each other, leading governments to offer them privileges that may not benefit the public, or to weaken useful rules so as to help some corporations succeed even at the cost of harming citizens. Examples of corporations undermining democracy through policy engagement are rampant in the financial sector and in the pharmaceutical, coal, and gun industries.
I first encountered these issues when looking at the banking sector after the financial crisis of 2007–2009, which led me to realize that many of the assumptions about markets and corporations that are routinely made in research and teaching about financial markets and corporations are false. The crisis was not, as some conveniently imply, akin to an unpreventable natural disaster; rather, it was the result of failed corporate governance and poorly designed and ineffective rules that tolerated waste, fraud, and an enormous buildup of unnecessary risk. The rules effectively rewarded recklessness and exacerbated the fragility of the system.
In Crashed: How a Decade of Financial Crises Changed the World, Adam Tooze describes how developments before 2007 and since, including the extraordinary actions by governments and central banks and the narratives and public anger surrounding the events, exposed the enormous harm that free-market capitalism and government failures can cause. The crisis transformed our economic, political, and geopolitical landscape in ways that continue to have substantial impact on us today.
Over the last decade, I have engaged with trying to improve the rules for the financial system, and I witnessed with dismay and concern how distorted incentives, averted eyes, and insufficient accountability have led markets and governments to fail society. The reformed rules after the financial crisis do not reflect the full lessons of the crisis and maintain a largely unchanged system that is inefficient, reckless, and opaque. Some rules are too costly and counterproductive, while others are unnecessarily complex, yet weak and inadequate, benefiting few and harming and endangering the rest unnecessarily.
A Focus on Enablers
In “It Takes a Village to Maintain a Dangerous Financial System,” I discuss the actions and motivations of the numerous enablers in the private sector, government, and even academia that are collectively responsible for this situation. These enablers remain unaccountable because the issues appear complex and confusing to the public. Flawed claims contribute to the confusion, muddle the debate, and continue to impact policy and cause harm. Creating a better financial system requires that citizens become savvier as consumers of the system and better informed about its flaws and what can be done to correct them. Teaching at universities can help, but much more is needed to challenge the entrenched system.
Similar problems arise in many policy areas in which experts might be conflicted and where the harm, or specific flaws in corporate governance and policy, are difficult for nonexperts to detect or know how to correct. Examples include financial disclosures, technology, and the environment. The recent scandal involving Boeing and the Federal Aviation Administration shows that even in aviation safety, distorted incentives in the private and public sectors can cause preventable harm. Other recent examples where corporations or government bodies caused or tolerated harm that their employees and leaders could have prevented but failed to do so are Purdue Pharma, Equifax, Theranos, Facebook, and Wells Fargo. Even when investigations reveal some of the culprits of harm, the typical outcome of excessive endangerment and misconduct by corporation is a fine paid by shareholders and minimal if any consequences for leaders, raising questions about the justice system in a corporate context.
So far, those in the business community and business schools concerned with the loss of trust in capitalism or with problems such as climate change and inequality have focused on private-sector solutions involving philanthropy, social entrepreneurship, and impact investment. Perhaps in response to backlash against their focus on “shareholder value,” 181 chief executives in the United States recently vowed, without being specific about how their practices might change, to consider all stakeholders.
Voluntary actions by the private sector can be useful, but they cannot solve society’s big problems or replace governments altogether. Worse, the focus on private-sector solutions perpetuates the flaw in Friedman’s analysis by ignoring the critical role that governments must play and distracting us away from ensuring that governments act properly in our collective interests. By assuming that governments are unable or unwilling to solve social problems, those who focus on private-sector solutions fail to ask why governments might be dysfunctional or to reflect on or take responsibility for their own role in causing harm or weakening governments.
Indeed, those who practice free-market capitalism today and count on governments to protect their property rights and safety may cause harm and undermine governments and democracy in their pursuit of profit. For example, to achieve success, managers may seek outsize subsidies and tax breaks and lobby to weaken beneficial safety standards or environmental regulations. They may also find it useful to confuse policymakers and the public so as to maintain market power or get away with reckless practices. Even if these actions do not violate the letter of existing laws, they may contradict the spirit of the laws and hinder their enforcement. And self-regulation is unlikely to suffice when stock-based compensation and pressure from aggressive investors create strong incentives to respond to the standard success metrics.
Transparency, Accountability, and Education
We can do more to tackle the governance problems at the nexus of corporations and democracy and improve the system. To root out subtle and often invisible forms of corruption and to ensure that markets, corporations, and governments serve society, it is important to place governments in a better position to design and enforce proper rules, including for markets and corporations, and citizens in a better position to hold all those in power accountable.
To be effective, government bodies need appropriate resources, unconflicted expertise, and capable civil servants who are not prone to being corrupted. Well-designed rules can correct distortions, protect the public, and help markets work better, but poorly designed rules can exacerbate distortions. The details may be complex, but at least some citizens should be able to evaluate the rules and they should help citizens to hold those who write and enforce the rules properly accountable. Academic institutions and independent media can play important roles by providing unconflicted expertise as well as exposing governance and policy failures. And it is imperative that more people see through flawed and misleading claims that can scare or confuse politicians and voters to benefit narrow interests. Such strategies must not win.
Education is key to achieving these goals. Business schools, in particular, should work to eliminate some of the information asymmetries that lead to flawed rules, deception schemes, and lack of accountability. More generally, higher education programs should practice and promote civic-minded leadership and emphasize the importance of good governance mechanisms. As I have proposed in a recent piece at Harvard Business Review, doing so involves nuanced discussions of policy challenges related to business and society, collaborations to break disciplinary silos, and broader engagement across identity groups to elevate the level of public discourse beyond ideology and anger. A better informed and engaged citizenry can push, among other things, for badly needed reforms to campaign finance laws, improved transparency for corporations, and policies to improve governance and accountability in all institutions.
We face significant challenges in ensuring that our institutions are trustworthy. But we must first look beyond simplistic and misleading narratives about our choices. We do not have to choose between capitalism and socialism or between markets and big government. Rather, we must work to create a system in which corporations can thrive without distorting the economy and democracy, and in which governments write and enforce proper rules for all. Better education on the issues would be a good start. It is up to all of us.
This article first appeared in the Winter 2020 issue of Stanford Social Innovation Review. It was part of a series of articles sponsored by the Ford Foundation called “Realizing Democracy.”
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