The Tough Reality of Capitalism

The euphoria over the political miracle in Eastern Europe is fading as the magnitude of its problems emerges. There is still much political work to be done, and everything could still go wrong. Increasingly, however, the focus of attention is shifting to economic problems.

At first, the economic problems will be those of short-term crisis management: containing hyper-inflation in Poland, stopping the hemorrhaging of skilled labor in East Germany, securing desperately needed foreign exchange almost everywhere. These are simple problems to understand, but they are difficult to solve. And if things go badly, no deeper issues will arise. Suppose, however, that in the next year or two things go well enough that the democracies in embryo survive and are ready to face the task of building a new society. What happens next?

Arguably that’s when the real problems begin. For if it survives its immediate crisis, the next task facing newly democratic Eastern Europe will be that of building a market economy--which means building capitalism. This is a task that nobody has tried before. Everywhere else in the world, capitalism grew more or less organically. And when Eastern Europeans see capitalism, they probably won’t like it. I don’t like it much myself. Unfortunately, there’s no alternative.

There was a time when Western economists tossed around the idea that the acknowledged virtues of a market economy could be achieved without the perceived vices of private ownership and great inequality of wealth. The American economist Abba Lerner and the Polish economist Oskar Lange proposed the idea of “market socialism.”

Under this system, the managers of state-owned enterprises would be instructed to act as if they were capitalists, choosing prices, outputs and inputs so as to maximize accounting profits. Instead of a centrally planned economy, one would have a decentralized system that responded to consumer demands. The difference from a capitalist society, however, would be that nobody would derive his income from profits. Managers of state firms would play at being capitalists, but at day’s end they would return their winnings to society and be rewarded only with a modest salary and the regard of comrades.

But market socialism was never tried--partly because it conflicted with Marxist dogma, but also because it was ultimately unworkable. You can’t really simulate a market system, with profits and losses as just scores in a game, for one overwhelming reason: risk. Firms may do badly either because they are badly managed or because they are unlucky. Suppose that a firm under market socialism does badly. Will you penalize the manager? If you don’t, you provide no incentive for good management. If you do, you encourage managers always to play it safe, never to take risks.

The only way to encourage risk taking where it is appropriate, without absolving managers from the consequences of their actions, is to place ultimate decision-making power in each firm in the hands of someone who will receive handsome rewards if the firm succeeds--and lose massively if it does not. And it is not sufficient simply to promise these consequences, since these promises will not be credible (There will always be a temptation to bail out the unsuccessful and to try to appropriate part of the gains of the successful): The reward for success must be a right, and the penalty for failure automatic.

But someone who holds decision-making power over a firm, bears the firm’s risk and is entitled to the rewards if the firm’s ventures bear fruit, is--whatever name you may call him--effectively the firm’s owner. In other words, a market economy cannot really function without capitalists. It can provide a safety net to keep people from falling too far and a progressive tax system to limit their rise; but even the most welfare-oriented market economies have a basic capitalist ethos that is completely foreign to Eastern Europe.

And now we come to the problem. Eastern Europe needs a market economy. A market economy must be a capitalist economy. But capitalism is, when one really comes down to it, not a very attractive system. Because the essence of private ownership is the need to couple risk with responsibility, capitalism is inherently unfair: It is a system of “from each according to his ability, to each according to his luck.” Because great rewards must be offered to induce the taking of great risks, capitalism is also inherently a system of great inequality, of often undeserved wealth.

Much of the rage of the East Germans against their rulers has been fed by revelations of corruption, of the luxurious lifestyles of high officials. Yet surely I am not the only one who has noticed how relatively modest the revealed luxury sounds. Ten-room houses! Four cars! The East Germans simply have no idea what a truly unequal society is like.

I would guess offhand that virtually any senior vice president at a Fortune 500 corporation lived more lavishly in 1988 than all but the very highest officials in Eastern Europe. There are tens of thousands of people in America and even in Western Europe who have achieved wealth through such doubtfully productive professions as risk arbitrage and real estate speculation on a scale that is probably inconceivable to Eastern Europeans. When they see how much inequality capitalism generates, there is bound to be a backlash.

Worse yet, how do we get there from here? These countries do not start from scratch. Who gets to own the existing capital? Privatization in Eastern Europe will not be like selling the phone company in Britain, where there are wealthy investors prepared to bid. In Poland or Romania, there is nobody to sell the assets to, except possibly to foreign investors. And as the apparent debacle over the Gdansk shipyards indicates, this too will not be easy. Be prepared for years of bitter controversy.

And yet there is no alternative. Eastern Europe must turn to markets not only to prosper, but also because democracy requires a decentralized market economy. That means that Eastern Europe must embrace capitalism--a system that is unjust, unequal, unattractive and unavoidable.