Capitalism is a “DDoLL.” I’m saying it in a silly way, to make it easier to remember, but the fact is that capitalist societies rest on three principles of effectiveness.
As I have argued before, it is useful to think of decentralized market processes as operating within three concentric circles: exchange, markets, and capitalism.
Exchange
The key to understanding exchange is Difference (the first “D” in DDoLL). Any agreement in a barter, or simple market exchange, requires a disagreement about value. If you haven’t taken a standard microeconomics class, you have likely never heard that, and probably haven’t even thought about it. But it’s the essential feature that makes voluntary exchange beneficial!
Consider: I have two apples, and you have two oranges. If I offer to give you one apple in exchange for your giving me one orange, I must value that first orange I get from you more than I value having a second apple. If you agree — no coercion, no gun to your head — then you must value that first apple from me more than the second orange that you brought to the table. Since you have the right not to trade, the fact that you want to trade means you are better off.
In fact, when the apple and the orange are exchanged, we are both better off, because we disagreed about the value of the property we started out with. We agreed on a “price” — one apple in exchange for one orange — only because we disagreed about the values involved.
All voluntary exchange involves disagreement about value, and any voluntary exchange that takes place makes both parties better off. The public policy implication is crystal clear: Create institutions for reducing the transaction costs of exchange. Of course, this may simply involve maintaining such transaction cost-reducing institutions if they emerge as a spontaneous order (a result of human action but not of human design).
Markets
The “market order” is nothing more than the predictable, persistent set of institutions and practices for reducing the transaction costs of exchange. A widely accepted money reduces the transaction cost associated with barter in the exchange stage; as do a legal system for defining and enforcing property rights, and a forum for adjudicating disputes over contracts, fraud, torts, and infractions against poverty; a transport network; a communications network; a system of uniform weights and measures; that sort of thing.
Consider: If four of us each must make our own clothes, grow our own crops, catch our own fish, and build and repair our own houses, we will be quite poor. But if one of us specializes in being a tailor, one a farmer, one an angler, and one a carpenter, then we are all better off because we can…. exchange! our developed talents, because of specialization, will create a new form of difference. Where exchange was based on a difference in taste, markets are based on a difference in capacities or abilities.
That kind of specialization is the origin of the emergence of market institutions, where we don’t have to barter our services, but sell stuff to each other for money, which can then be saved or used to buy other things. Things really take off, however, when the system moves from simple specialization of individual artisans to actual Division of Labor, the “DoL” in the middle of “DDoLL.” What I mean is that two of us decide to specialize in making clothes, one cutting the cloth according to patterns, and the other sewing together the cut cloth into garments. The other two of us might decide to go out after fish, using a boat so many more fish can be caught. One person rows the boat and minds the catch, and the other specializes in using a net to catch fish.
All four of us, because we are working on a single, smaller task, become more dexterous and learn to develop specialized tools for cutting, sewing, rowing, and netting. The two clothing makers produce more than twice as much as the single specialized tailor artisan could make, and the two anglers catch far more than twice as much fish as the single angler working alone could manage.
The problem, as you’ll already have recognized, is that the four now need to depend on some outside source for their vegetables, and their carpentry work. But notice also that beginnings of division of labor have produced a surplus, an amount of clothing and fish that exceeds the amount that the original four can consume. That surplus is available to offer in exchange for the surplus created by farmers, and home-builders, in the next little village. We are obliged to find new ways to cooperate with other people, people we may not know.
In a simple exchange-barter setting, this expansion of “the extent of the market” would be cumbersome. But as money, property rights, and legal norms emerge, division of labor can expand. Eight people can be much more wealthy than four, because of division of labor. One thousand people can be unimaginably more wealthy than eight people. Division of labor is the most important source of increasing returns to scale in the market system.
But as Adam Smith said — and almost no one recognizes the full importance of this observation — “the division of labor is limited by the extent of the market.” The division of labor proceeds until it reaches the limitation imposed by the size of the cooperation horizon: the number of people to be organized by the decentralized calculus of profit and loss in commercial enterprise.
Capitalism
Very few people, in my experience, have any idea what capitalism is (though many of them know they don’t like it!). Markets commodify goods and services; capitalism commodifies profit and loss itself. The ability to buy and sell “shares” of ownership, and “derivatives” such as options that further uncouple ownership of the “stock” from ownership of changes in the value of that stock, enables investors to do two essential things.
First, and most importantly, capitalism fosters the creation and direction of “liquidity” (the final “L” in “DDoLL”). Liquidity is mobile, amorphous value, which can be used to form resources into almost any kind of productive capacity that is technologically feasible. That’s why it is “liquid”: liquid capital can become a factory, a dam, a restaurant, or anything else that the human imagination can generate and that engineers can try to build.
Consider: Liquidity is like a kind of fire hose of yet-unformed value. The fire house is directed by the owners of liquid assets, and is converted into physically specific, and literally concrete, assets that are used to produce value in markets that elaborate division of labor. There are winners and losers in this system, as the system of profit and loss renders judgments on the social value the way liquid capital has been directed. This specter of loss disciplines investors, just as the prospect of profit motivates them to take risks in the first place.
The DDoLL
That’s the story of capitalism. Exchange creates value out of difference; markets create value out of division of labor; and capitalism creates value out of the investment of liquid capital. People who say they “oppose” capitalism fail to realize, in my experience, that for all its flaws capitalism is the only system that can deliver on the promise of human flourishing and reduce poverty. It’s not even clear that there is a viable system that comes in second.
