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My long-promised post on capitalism and socialism

July 31st, 2002

A lot of confusion in policy debate today surrounds the use of the terms ‘capitalism’ and ‘socialism’. Although there are a lot of different abstract definitions of these terms, a reasonably neutral pair is (Definition 1)
‘Capitalism is a system where economic decisions are made in response to individual preferences as expressed through markets.’
‘Socialism is a system where economic decisions are made in response to judgements about social need expressed through democratic politicial processes.’
The problem with definitions like these is that they aren’t really operational. That is, it’s hard to look at some particular economic system and say whether it’s capitalist or socialist. So it’s useful to look at some simplifications that lend themselves to easy tests. The most straightforward (Definition 2)
Capitalism is a system where goods and services are produced and distributed through markets
Socialism is a system where goods and services are produced and distributed by governments.
Finally, there is a pair of very simple and widely used definitions based on official ideology (Definition 3)
Capitalism is the economic system prevailing in developed Western countries
Socialism is the economic system that prevailed in the former Soviet Union

Now let’s look at a couple of statements that are commonly made about capitalism and socialism. Statement 1
‘ The battle between capitalism and socialism is over. Capitalism won’
This is obviously true in relation to Definition 3, but clearly false in relation to Definition 2. The ratio of government expenditure to GDP is at or near its all-time high in most countries and is reasonably close to 50 per cent. That is, the actual economic system in Western countries is a ‘mixed economy’. So, on Definition 2, we could reasonably say
‘So far, the battle between capitalism and socialism looks like a draw’
It’s a bit harder to assess specific statements in relation to Definition 1. Even though government didn’t shrink much in the 1980s and 1990s, the role of markets relative to governments was clearly enhanced. So, on Definition 1 we might say
‘Capitalism has won most rounds in the past twenty years, but is a long way from scoring a knockout.
Now lets look at a second statement (2)
‘In a capitalist system, governments don’t make investment decisions. That’s the job of markets’.
This claim is clearly true on Definitions 1 and 2, but clearly false on Definition 3. In all OECD countries, governments have a big say in a wide range of investment decisions.
Unfortunately, a lot of people on the right try to argue from statements like 1 to statements like 2. The typical argument (with internal contradictions exposed) runs like this. ‘The relative success of Western economies proves that capitalism (Definition 3) is the best economic system. Therefore we should replace the economic system in Western countries with capitalism (Definition 1 or 2).’
Similar contradictions can be found on the left, and were particularly prevalent when the Soviet Union was still around. A typical version runs something like this.
‘ Socialism (Definition 1) is more morally attractive than capitalism. Therefore, we should support socialism (Definition 3) as represented by the government of the Soviet Union.’

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