Crony Capitalism vs. Free-Market Capitalism

Many people, especially progressive Democrats, confuse crony capitalism with free-market capitalism. This confusion is part of the religious faith of the woke. Capitalist corporate officers are viewed as among the elites that oppress the common people in capitalist societies. That oppression springs from government granting them special privileges. For this reason, all capitalists must necessarily be crony capitalists. It then follows, according to the basic theology of the woke, Critical Theory, the institutions allowing the existence of the crony capitalists must be torn down, root and branch.

Yet, crony capitalism is the very opposite of classical, free-market capitalism. Nevertheless, progressives tend to believe crony capitalism is the only kind of capitalism that exists. What they do not seem to realize is that only government policies can produce crony capitalists. If progressive Democrats and the woke can be persuaded of this, a substantial first-step could be made to convert them to the faith of the Age of Enlightenment.

What Free-Market Capitalism Means

In 1776, the Scottish moral philosopher Adam Smith published the book An Inquiry into the Nature and Causes of the Wealth of Nations, more commonly referenced as The Wealth of Nations. It created the idea of free-market capitalism that was one of the last fruits of the Age of Enlightenment.

Smith wrote the book to contest the reigning economic philosophy of the time, known as mercantilism. Mercantilism had dominated Europe for approximately three and a half centuries from the 15th to the mid-18th century. A primitive precursor to mercantilism is bullionism, which defines wealth as the possession of precious metals, particularly gold and silver. As mercantilism developed as an economic philosophy, bullionism continued to be a part of it as mercantilism’s monetary doctrine. Mercantilism was a form of  economic nationalism. Its main goal in any particular country was to enrich the nation by making it independent and self-sufficient, not dependent on any other country. This economic autarky is probably the single most important aspect of mercantilism.

Smith attacked mercantilism first by disputing mercantilism’s definition of wealth through bullionism, and second by constructing a completely new replacement philosophy of economics. Over time, it has become called laissez faire capitalism. 

In the process, Smith invented the idea of an invisible hand that almost magically guided individuals to seek what is good for all in seeking their own good.

This invisible hand is not the hand of God. In reality, it has only two fingers, which are the law of supply and demand and the law of marginal utility. The law of supply and demand determines on average what prices will be charged for any particular quantity of goods offered for sale. It is usually described graphically in terms of Alfred Marshall’s supply and demand curves. These curves for some particular good or service will look somewhat like the diagram below.

The supply curve is labeled S in the graph while the demand curve is labeled D. The vertical axis gives the number of goods either sold (in the case of the supply curve) or bought (in the case of the demand curve). The horizontal axis gives the price at which the good is bought and sold. Obviously, the points on these curves represent an average of prices and quantities found in a real market. If you tried to construct actual supply and demand curves, you would find a scatter of points around the curves. The point of their intersection gives the market equilibrium price. At that point the consumer is willing to pay what the producer of the good asks. Also, most importantly, the consumers buy exactly the amount that is produced. There is no waste.

However, the supply and demand curves  are always changing. Such changes are caused by such things as new technology, changing values of goods due to changing desires, changing availability of raw materials, etc. What happens after such adjustments is described by the law of marginal utility. Marginal utility provides the necessary feedback in a changing society to move toward a new homeostatic equilibrium.

The law of marginal utility  is the fusion of two parts. The first is the idea that it is the utility or usefulness of something that gives it its value. The idea that value equals utility actually has a larger applicability, as developed by the founders of utilitarianism, Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1873), than just in economics. 

The second part of the law of marginal utility was supplied by the founders of the marginal utility revolution in 1870: Carl Menger, Leon Walras, and William Stanley Jevons. They independently noted that as the supply of a good  increases, the price of the last good sold (also known as the marginal utility) decreases. This is because the supply of a good becomes increasingly less useful as the consumer’s need is fulfilled. Once a consumer has no more need for the good, he will not pay anything for it. This view of marginal utility presupposes the utility theory of value.

How does the law of marginal utility relate to Marshal’s supply and demand curves? Suppose that the demand curve is initially given by D₁ as shown in the figure below. We then suppose that for some reason  that the supply of the good increases to an extent that the market is partially saturated with the good. Then the consumers would buy a smaller number of the good at the same price as before the change. This means the demand curve would be shifted to the left to some new demand curve D₂ as shown in the figure.

If for some reason the supply curve does not change, i.e. the suppliers have some inertia in changing their behavior, the new equilibrium price point where the two curves intersect will be at a point where both the price and the quantity sold will be smaller. After a while, however, the producers may decide they can maximize their profits at a lower price by producing the same number of goods as they were capable of before. If that happens the supply curve will also shift to the left until the intersection with D₂ is at a new equilibrium point where the quantity bought and sold is the original quantity with the equilibrium market price decreasing even further. This kind of behavior is often observed in markets when new technology and/or sources of supply are discovered that increases available supply at the same or lower cost.

Together the law of supply and demand and the law of marginal utility form Adam Smith’s invisible hand. The invisible hand is the defining characteristic of free-market capitalism. However, many times we see the actions of government constraining the hand by not allowing the supply curve to shift optimally. This happens when the government begins intruding on the economy through such actions as wage-price controls, deciding the allocation of capital, and constraining the operations of companies through economic regulations. Then instead of free-market capitalism, we find crony capitalism in its stead.

What Crony Capitalism Means

Explaining crony capitalism is much easier. According to the Oxford Dictionary, crony capitalism is “an economic system characterized by close, mutually advantageous relationships between business leaders and government officials.” The Merriam-Webster Dictionary says crony capitalism is “an economic system in which individuals and businesses with political connections and influence are favored (as through tax breaks, grants, and other forms of government assistance) in ways seen as suppressing open competition in a free market.” Those business leaders, the crony capitalists, do the bidding of government officials, in particular bureaucrats in the regulatory state, the President, and members of Congress. In return, government grants benefits to those businesses that cooperate.

Progressive Democrats will swear with the greatest sincerity they are inherently against crony capitalism. It was their perfervid opposition to crony capitalism that gave rise to the progressive movement in the late nineteenth century. Yet, their drive to control ever more of the American economy is the single biggest reason for the growth of crony capitalism. For more than a century, ever since the administration of Woodrow Wilson (1913-1921), the U.S. federal government has been gathering increasing power over companies through the regulatory state.

The more the U.S. government controls the economy, the more the crony capitalists will seek government favors. The more that corporations seek government favors, the more excuse government officials, especially those in the regulatory state, have to gather further economic control. In this circular process, corporate officers gradually become apparatchiks of the state.

It is not just by the growth of the regulatory state that government gains control over crony capitalists. Progressive-controlled government also accomplishes this simply by increasing the fraction of GDP they spend. The whole purpose of progressive Democrats is to direct the nation’s economic assets to attack what they consider social problems. The more government expends as a share of GDP, the more private companies depend on government contracts for their own profits.

However, the more government spends as a share of GDP, the more it destroys its own capability to do anything. This comes about because of the interaction between Hauser’s Law and Rahn’s Law. Hauser’s Law states that that no matter what the top marginal tax rates, federal tax receipts have stubbornly averaged 19.5% of GDP, plus or minus a few percentage points. In fact, the largest fluctuations from the 19.5% average are downward, and are lagging indicators of particularly severe recessions.

Hauser’s Law arises because of the highly progressive nature of U.S. income taxes. Consider the plot of the distribution of income taxes by income group for the year 2020 shown below. It was produced by the Tax Foundation using IRS data.

A little addition shows the top 25% in income provide 66.1% of federal income tax revenue. The top half in income provide 72.6%. Since the income of the richest depends on the GDP, this ties Federal revenues to the size of the GDP.

However, Rahn’s Curve shows as government expenditures increase as a fraction of GDP, GDP growth rates fall for developed economies. This can seen in the plot below. It is a scatter plot of GDP growth rates for developed OECD nations in 2013 as a function of their government expenditures.

Clearly, growth rates fall as government increases the fraction of the country’s GDP it spends. This plot strongly suggests one can expect growth rates to become negative once government spends a little more than half of the GDP. Should the U.S. ever reach this point, the federal government’s income tax revenues will become about 19.5% of an ever diminishing GDP. How desperate will crony capitalists be for government largesse then?

American crony capitalists are the counterparts of the Russian oligarchs. Because the Russian means of production are primarily owned by the Russian oligarchs, while their economy is completely controlled by the government, Russia is a fascist state. Fascism is a form of socialism that is only cosmetically different from communism. If all this suggests to you American progressives are would-be fascists, congratulations! You are thinking logically.

The Encouragement of Growth with Free-Market Capitalism

None of all this means government lacks the ability to encourage economic growth. What it does mean is government should as much as possible not decide how the country’s capital assets are allocated. Again, as much as possible, economic regulations should be the same for all companies and individuals. Those economic regulations should also leave as light a footprint as possible.

Probably, the most certain way to turn away from crony capitalism back toward free-market capitalism would be to eliminate all income taxes on companies, small and large alike. Since companies are society’s primary producers of new wealth, giving them additional assets for investing in new productive capacity, hiring, and rewarding labor will benefit everyone in society. Also, eliminating corporate income taxes would take one major lever of control over capitalist institutions from the government.

Progressives often claim the elimination of corporate taxes would unfairly benefit the rich owners of corporate stocks. However, as long as corporate earnings are retained within the company, they cannot benefit the rich as income. The rich benefit from corporate profits only when: (1) the profits are paid out as dividends, or (2) the rich sell their stock. In either of those cases, the increased income of the rich is taxable as new income or capital gains.

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