Capitalism and Democracy

In the Italian elections, the party that showed the strongest results was the Five Star Movement, led by the comedian Beppe Grillo. Despite this strong showing, the party failed to form a government and refused to participate in any coalitions. This decision not to participate in the political process has been exhibited by other protest groups, such as Occupy Wall Street, the Israeli Tent Movement, and the Spanish “Indignant” movement. All these movements involved social protests, but one of them had a clearly defined political program; they all seemed to be pressing for economic equality but none seemed to have any desire to join any established political party. Grillo has been quoted as saying, “We die if a movement becomes a party. Our problem is to remain a movement in parliament, which is a structure of parties. We have to keep a foot outside.”

What has caught our attention is the pattern of all these movements to avoid political involvement. Usually, movements like these eventually either develop into political parties or become pressure groups which become advocates for their particular positions. The decision not to become involved in the political process suggests that they don’t believe it can make a difference. If there is a lack of faith in the political process, it raises serious concerns about future social stability in many otherwise stable societies.

In this report, we will offer a brief history of the evolution of democracy and its relationship with capitalism. From this point, we will examine changes that have developed over the past three decades that have reduced the ability of any one nation to implement social policies in isolation. This change, accompanied with modern election practices, has driven up the cost of campaigns and has forced candidates to focus an increasing amount of time and energy on fundraising. The need to raise money and the influence of these financial flows affect the political process. We will then examine the potential fallout from a significant portion of the Western population deciding that elections don’t matter. As always, we will examine the ramifications of this situation on the financial and commodity markets.

The Relationship of Democracy and Capitalism

Using private markets as the primary method of creating and distributing goods and services is very common in most Western democratic countries. However, this relationship is not necessarily causal but coincidental. There is nothing inherent in capitalism that requires a democratic government. In fact, fascism operates on the principal of capitalism within a single-party state. It is arguable that Japan maintained a fascist political system with a market economy after WWII. Although elections were held on a regular basis, the Liberal Democratic Party dominated the political apparatus and held control of the government on a nearly continuous basis for nearly 60 years. China’s current political system is authoritarian with a mostly market-based economy.

In the political development of Western Europe, democracy movements were tied to the undermining of absolute monarchies. In England, the landed aristocracy, along with the emerging merchant class, forced the royal families to relinquish power. Initially, constitutional monarchies developed but over time most royal families became only nominally tied to governing.

The intellectual ferment that led to the end of absolute monarchy was also tied to individual freedom. The Enlightenment rejected the authority of religion and tradition and stressed reason and individual freedom. Capitalism dovetailed into the movement well. The emphasis on individual freedom raised concerns about societal welfare. However, David Hume’s argument that the only structure that could corral self-interest was self-interest eventually was expressed in a famous passage by his more famous protégé, Adam Smith.

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.1

Essentially, what capitalism provides is a way to create a functioning society by allowing individuals to pursue “life, liberty and…happiness.”

Interestingly enough, Hume argued that justice only occurs between equal parties. Interactions between unequal partners fell under the relations of mercy and charity. From Hume’s perspective, only equal parties could negotiate a just transaction since neither had an advantage over the other. To a great extent, Hume’s view on justice was a harbinger of the tensions that would develop between capitalism and democracy.

The early democratic governments, although they often held hotly contested elections, were hardly a reflection of the “will of the people.” Instead, they were a reflection of the “will of the voters.” Suffrage was hardly universal. There was broad discrimination by gender2 and by race. Age is also a universal voting restriction. Most democratic nations don’t allow children to vote, working under the assumption they are not mature enough for such an important decision. Throughout history, in many nations, the vote was only granted to property owners (although a major impediment in Europe, in the U.S., land was widely available and so ownership restrictions were less onerous).

Industrialization exposed a serious rift in society and, consequently, in democracy. The owners of capital wanted to run their businesses unfettered by government interference or social restrictions. Workers wanted protections from perceived abuses of owners. Karl Marx argued that capitalism has internal “contradictions” which are not the same as logical inconsistencies but more akin to unsustainable outcomes that occur once conditions are taken to their logical conclusion. For example, owners have an interest in paying the lowest wages possible, but if all owners follow that plan there may not be enough consumers to buy their products. Based on Hume’s concept of justice, workers are not equal partners with capitalists. They need the means of production that owners provide and cannot make a living without them. Workers in this situation must either petition the owners for mercy or increase their power to become an equal partner. The former path isn’t promising; to attain the other, workers have generally enhanced their power through political involvement.

For example, Beth Simmons argued that the universal gold standard, which lasted from 1880 until 1914, existed because common workers, who bore the brunt of deflationary policies, faced voting restrictions.3 After WWI, suffrage expanded and workers voted against deflationary policies that favored the creditor class. This expansion of suffrage doomed the gold standard. We suspect that most political figures calling for a return to the gold standard are probably not aware that the successful functioning of that standard would likely require a restriction on suffrage. On the other hand, the lack of political participation by the aforementioned protest groups may simply reflect the belief that attaining the vote is immaterial if the choices fail to favor their goals. In other words, the political conditions that fostered the gold standard, which favored creditors, may already be in place!

In the late 19th and into the 20th century, the political system intervened to reduce the power of owners and bring a modicum of Humean justice. In the U.S., William Jennings Bryant pushed for inflationary policies to help debtors in his famous “cross of gold” speech at the Democratic National Convention in 1896. Teddy Roosevelt championed the Progressive Movement which broke up the “trusts” which were large industrial conglomerates. An income tax was introduced in 1913 in the U.S.

Since the late 1800s in the U.S., in a pattern that has been repeated in other nations as they industrialized, the political powers tended to try to create a balance between the owners of capital and workers. Simply put, the political arena is where these two powers work out their differences.

Efficiency versus Equality

This tension was well described by Arthur Okun.4 The political process must weigh the needs of society and the overall economy by balancing the needs of workers and owners. An economy struggles to grow when entrepreneurs are restricted by rules and regulations to the point where risk-taking activities are squelched. At the same time, if there isn’t some degree of fairness, workers simply don’t earn enough wages to create sufficient demand. History shows that nations that are in the early stages of development usually must offer entrepreneurs wider berth to build the economy. Over time, there tends to be a swing toward workers’ rights as the economy develops. It is the argument about expanding the “pie” as opposed to dividing the “pie.” Without growth, there is less to divide, but if the pie expands and only a few gain from the expansion, the political and social support for entrepreneurship is undermined. Thus, in Okun’s words, the political process must divine the right balance of equality and efficiency.

In general, capitalist economies will never be equal. Some degree of inequality is necessary to spur individuals to take risks and create new businesses. In addition, there is a natural dispersion of talents and opportunities which will lead to inequality; even if all opportunities are equal, differences will develop.5 At the same time, if society becomes so unequal that it seems static, where the poor can never advance and the rich always dominate, the conditions for revolution develop. Capitalist democracies have tended to resolve this difficulty by creating conditions of “equality of opportunity.” Public education, training schemes, job matching services, unionization and transfer payments are part of this process. But, ultimately, the political process is where the decision to lean toward one group or the other is made. The structure of government matters little in the process; authoritarian regimes and democracies face the same issue. Both President Obama and General Secretary Xi must deal with these tradeoffs.

Abandoning the Political Process

This is why the recent pattern of avoiding the political process by the aforementioned protest groups is unsettling. Disagreements between capitalists and workers are nothing new. Balancing these interests is accomplished via the political process. The decision not to participate in the political process raises serious questions. First, why have they decided not to participate? And second, what are the ramifications of this lack of participation?

Why have these groups decided their needs won’t be met in the political process? It appears they believe that governments lack the power or the will to respond. Globalization has played a significant role in changing the nature of the political response. The impact of globalization was probably first evident in the early 1980s when French President Mitterrand tried to jump start growth with fiscal stimulation. The program failed miserably because the increased consumption merely led to rising imports and a currency crisis. Over the past three decades, numerous other events confirmed this growing impotence. When David Letterman suggested that U.S. fiscal spending after the 2008 crisis effectively raised employment, in China, it wasn’t just a joke! Essentially, in a globalized economy, an individual country’s policies can be thwarted or magnified based upon policies elsewhere. Governments are finding that their ability to stimulate growth or contain inflation is deeply dependent on global conditions. As governments begin to realize their limits to power, elections become more like popularity contests; the actual ability to change conditions is quite limited.

At the same time, businesses find that they must conduct their activities with an eye on the global markets. A firm that tries to maintain a local manufacturing presence in a developed economy will face strong competitive pressures from other firms that have globalized. The globalized firm tends to enjoy greater productivity and lower wage costs, putting the localized firm at a disadvantage. In a related trend, Chrystia Freeland6 discussed the rise of the global elite, suggesting that a group of interconnected bankers, entrepreneurs, academics and professionals have become tied together on a global scale and had more in common with each other than their countrymen. And so, the members of the new global elite are more inclined to support their emerging “class” (think of the “Davos man”) rather than their fellow countrymen. Improved communication technology and the ease of international travel have created the global elite that have become delinked from conditions in any particular country.

The influence of campaign funding has also increased. In democracies, lobbying is nothing new. However, the cost of elections has reached such high levels that individual politicians, unless independently wealthy, are forced to woo donors for funds on a continual basis. At the same time, major donors, either right or left wing, have become increasingly sophisticated in their requests from the political class.

In such an environment, there is little that any political figure or industry leader can do to offset the impact of globalization. Once globalization is coupled with technology, it can appear that unseen forces of great power are driving policy, depriving a voice or power to local citizens.

The Consequences

It appears that these forces have turned the aforementioned movements against the political process. These groups seem to have determined that it is impossible to compel the political process to address their needs. In effect, they see the political process as rigged, that governments cannot withdraw from the interconnected web of globalization and so to become part of the political process will eventually fail.

So, how do governments respond? Traditionally, there have been three tactics. First, there is an attempt to create conditions that may allow the disenfranchised to participate (the aforementioned equality of opportunity). When governments offer training, job information and education, the goal is to create workers that can function in a highly competitive global economy. Government and society try to create conditions of social mobility. Not only does this allow a poor but talented person a chance to advance, it creates social stability by offering a fair chance. Of course, if the general perception is that opportunity has been offered, anyone who fails to compete is responsible for his/her own shortcomings.

However, there are concerns that these measures are failing. Studies are suggesting that social mobility is stagnating in many developed nations. Public education is spotty in many nations; schools in poor areas are often less rigorous than those in richer areas. The social disciplines that are exhibited by the upper and middle classes, such as timeliness, dedication to the task, marital fidelity, etc., are breaking down among the poor. Increasingly, demographers are noting that there is less status and class distribution in marriage and housing; upper class members are tending to marry each other and live near each other. The lower classes are making the same sorting process. Simply put, the avenue of “marrying up” is becoming less common. In the U.S., for example, divorce is becoming less frequent among higher income families but remains high in lower income families. Divorce tends to exacerbate the evils of poverty. All these social problems have tended to undermine government efforts to narrow income differences.

The second way governments have tried to equalize income differences are through transfer payments. Tax rates are made progressive and income support is given to lower income families. However, political support for such programs is being undermined by two trends. First, the global elites will obviously prefer to avoid living in nations with strong income support (as they tend to have high and progressive taxes) and are now mobile enough to fulfill that goal. The recent attempt by the Hollande administration in France to raise marginal taxes has led to a high profile exodus of wealthy Frenchmen. Although the numbers themselves may not be large, the potential for high earners to leave acts as a deterrent for governments to reduce income differences through tax and welfare policies. Second, the global elites have become more powerful due to the high cost of the political process. As such, they can more effectively oppose policies such as these through lobbying and campaign contributions.

The third method that governments have employed is tilting the environment to support labor unions. These unions not only work to boost wages, they also create work rules which act as a regulatory cost for business. These work rules tend to undermine managers’ attempts to lift productivity by forcing certain rules to be followed, even if automation or other labor saving procedures would reduce costs.

Prior to the 1980s, when globalization took hold, unions in most developed nations were strong. However, as businesses competed on a global scale, the ability of unions to dictate rules and wages collapsed. Capital became mobile and could move production to more favorable venues. The emerging economies offered low cost and flexible manufacturing capacity that supported offshoring. This condition undermined the ability of governments to use unionization as a tool to reduce inequality.

The Conundrum

In Europe, we are seeing a backlash against austerity. The new Italian Prime Minister Enrico Letta warned German and other EU officials that his citizens had reached the point of intolerance to further austerity measures. Similar complaints have emerged from Spain, France and Portugal as well. Southern Eurozone nations have suffered through painful economic contractions as the governments try to reduce their debt exposure through austerity. However, while there is a growing backlash against austerity, as the example of Italy shows, it isn’t necessarily being resolved politically.

Labor unrest has been increasing in China as the steady stream of rural immigrants appears to have stopped, forcing manufacturers to lift wages. Of course, this puts China’s economy at risk and has led to increased automation and a shift to higher valued products. Lower skilled manufacturing is now shifting to other newly industrializing nations.

In the U.S., outside of the Occupy movement, the social situation remains relatively calm. However, the electorate is deeply divided and income differences continue to widen. There have been some increases to taxes on upper income households, but nothing like what was seen in the 1950-79 period. The populist backlash against immigration in the U.S. is, in part, due to frustration about wage stagnation.

Thus far, this widespread anger about income issues, which is significantly affected by globalization, has not led to a serious backlash against the current political structure. However, it is obvious that leaders in Europe are concerned; in fact, we expect some retreat from austerity due to these worries. In the U.S., frustration over these issues has mostly been exhibited in deep political divisions. There is, at best, mixed support for income redistribution and little pressure to interfere with international trade.

However, it isn’t obvious how long this relative calm can continue. If labor markets improve in the coming months, some of the social pressure will ease. The Federal Reserve’s aggressive policy accommodation is said to be specifically targeted to labor market conditions. Unfortunately, there is little evidence that lower interest rates or increased liquidity will do much to help the long-term unemployed.

And so, the significance of the aforementioned protest movements and their specific desire to remain outside the political system is unsettling. In previous periods where political and economic conditions appeared irresolvable, anarchy movements developed which engaged in terrorist activities that had no obvious goals. Broader revolutions have also developed from such conditions.


Clearly, the evolution of these movements bears watching. Globalization has been a force for good; millions of people in less developed nations have improved their lot and the goods they produce have reduced inflation in the developed world. However, it is also clear that governments have seen their ability to affect policy reduced. Since the political process is where equality and efficiency are balanced, nations are struggling to integrate this process into a globalized and interconnected world.

In the short run, this problem will likely be expressed in the foreign exchange markets. Nations facing falling incomes may try to boost growth at the expense of their neighbors through a weaker currency. In fact, the U.S., as the global superpower, has allowed nations since WWII to export their way out of economic stress to ensure global stability. A case can be made that the U.S. followed this strategy to support Asia’s recovery from its economic crisis in the late 1990s. Of course, without some nation willing to play this role of global importer of last resort, beggar thy neighbor policies are not a long-term solution.

In addition, unconventional monetary policies will likely continue to be deployed and maybe expanded, especially if fiscal policy cannot effectively stimulate growth or address income differences. Unconventional monetary policies are not designed to fix income issues but can lift growth through cheaper borrowing and a weaker currency. However, the potential side effects of creating asset bubbles limit the effectiveness of such policies.

The longer term risk is that nations will simply try to reverse globalization. The leftist governments in Latin America (Venezuela, Bolivia, Argentina) have tried, in varying degrees, to limit the intrusion of global markets. Their success has been limited; in most cases, they regain the ability to redistribute income but the process of withdrawing from the world tends to cause inflation and weaker growth. In effect, withdrawing from the world tends to “shrink the pie,” making the gains from redistribution less attractive. However, so far, a major power has not taken this action. If this were to become the norm, conditions that led to WWII would be in place; in the 1930s, the British, who were becoming unable to play the role of the global superpower, failed to offer a plan to allow economies to recover from the early stages of the Depression. The U.S., who had the capacity, lacked the political will to act. As the world became less integrated, politically extreme solutions became more acceptable.

Although hard assets have performed poorly over the past year, in the long run these offer the best protection from the risks described in this report. If the world deglobalizes, there will be a premium paid for critical resources that the markets may not reliably supply. Although deglobalization may not occur, as we have noted, the risk is rising due to the inability of nations to provide the role of arbitrating the tradeoff between equality and efficiency.

Bill O’Grady

May 20, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

1 Smith, Adam, The Wealth of Nations, Modern Library Edition, 1937, page 14. Originally published 1776.

2National suffrage for women did not occur until 1920 in the U.S., and in England, from 1918-28, only women with property, older than 30 or graduates of a U.K. university could vote. Men could vote after 21 with no such qualification.

3 Simmons, Beth, Who Adjusts, Princeton University Press, Princeton, NJ, Second edition, 1997, ppgs. 20-33.

4 Okun, Arthur, Equality and Efficiency: The Big Tradeoff, The Brookings Institution, 1975.

5 Hume, David, An Enquiry Concerning the Principals of Morals, 1777, republished by Open Court, La Salle, Il, 2nd edition, 1966. “…perfect equality may seem…at bottom, impracticable; and were they not so, would be extremely pernicious to human society. Render possession ever so equal, men’s different degrees of art, care and industry will immediately break that equality.”

6 Freeland, Chrystia, “The Rise of the New Global Elite,” Atlantic Magazine, Jan/Feb edition, 2011.

© Confluence Investment Management

© Confluence Investment Management

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