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Capitalism’s Fundamental Flaw

Posted on Tuesday, Sep 28th

Growing up in pre-liberalization India, I embraced Ayn Rand as the one who best articulated a philosophy that rang true to my naturally entrepreneurial mind. Capitalism, meritocracy, individualism, self-correcting market economics, innovation, excellence, integrity, fairness, work-ethic, justice–many of the values that I worship are also those that Rand celebrates in her fiction through her unforgettable characters.

But as I have developed a deeper understanding of how capitalism works today, I am beginning to see flaws that are unlikely to correct themselves.

To be fair, most flaws will self-correct. For example, in the venture capital industry, we have seen a decade-long scam of taking limited partners for a ride, raising big funds, extracting large management fees to the tune of millions annually, and then returning negative on the investment. This, for sure, has already started self-correcting. According to the National Venture Capital Association, the number of venture funds declined to 1,366 in 2008, down from 1,883 in 2001. In 2009, this decline continues, and over the next decade, I believe, both the number of funds and the amount of money going into venture capital will go down significantly.

This is pure capitalism at work. Investors and limited partners come to realize that funds are not performing, and they pull the plug on them. Non-performing funds die, those that do well survive, new funds crop up and the industry as a whole gets right-sized. Some looters get away with their riches, but mostly, their careers are over.

Also, in the recent financial crisis, we’ve seen the government intervene on a massive scale, including putting billions into dead or dying companies such as General Motors. Thankfully, however, the government did not continue to do so, and GM entered bankruptcy as it very well deserved. No matter how stupidly Michael Moore’s new film, Capitalism: A Love Story, argues that GM owed its plight to management not respecting the unions, most intelligent people acknowledge that it was the union-enforced inflexibility that brought about the outcome. Here too, capitalism is doing its job of self-correcting.

The banks, however, are another matter altogether, and this is where I think capitalism has hit a roadblock. The government has intervened to save many of them, and now, these bailed out banks want to hand out billions in bonuses to their non-performing employees. Capitalism gave way to welfare economics, and now the government has to intervene further to limit these looters from behaving badly by imposing taxes and regulations. A whole messy cycle that brings me to the core “bug” in the system that Rand once sold me on, fully and completely.

Too many sacred tenets in Rand’s philosophy stand violated. Integrity, justice, fairness, work-ethic, excellence–all have fallen prey to greed. Rand’s flaw? She assumed integrity is implicit in the characters of the “leaders.” It isn’t. And hence again, most intelligent people are coming to the conclusion that the government must intervene to stop further shameless looting of taxpayer money. Free-market capitalism gets halted, regulation makes sense.

But there is another less obvious bug in capitalism that I don’t believe regulation can quite handle. It is the fundamental flaw that our celebrated system rewards speculators much more than creators. A relatively junior hedge-fund manager or a bond trader on Wall Street makes a great deal more money in his career than Charles Kao, who invented the basic physics making optical communication a reality. Dr. Kao, now 73, won the Nobel Prize this year, but his net worth would not compare favorably with that of George Soros.

Yet, who added the real value? Soros or Kao?

In 2009, 30 million people sit unemployed in America. Yet, the speculators have managed to lift the stock market up, and the media pretends that we’re having a recovery.

We’re not having any recovery. We need the innovators, the entrepreneurs, the creators, the scientists, the technologists–those who build value, those who create jobs–to lead us out of this nightmare. Not a bunch of speculators who make money regardless of whether value gets created or destroyed. In fact, many of them are incentivized to destroy value by spreading fake rumors about companies and stocks, and they do so often. Some get caught, most don’t.

And our talented youth gets seduced by this profession of speculation known for its easy and abundantly flowing financial rewards, avoiding those that require much greater intellectual capacity. Most importantly, very early in their lives, our talented youth come to realize that fields that may earn them a Nobel Prize–cancer research or multi-core computing–may not make them rich. But moving money from here to there will.

And thus, we lose Berkeley Ph.Ds in nuclear physics to hedge funds and MIT computer scientists capable of delivering computing to six billion people to derivative manipulation on Wall Street.

Ayn Rand, somewhere down the road, you lost me. I don’t see how free market capitalism fixes this systemic flaw.

And I am deeply disturbed.

Note: This article was first published on Forbes.

[Also see this series on Capitalism 2.0 for detailed discussions on Regulation, Integrity, Speculation vs. Value Creation, Justice, Excess, Welfare, etc. and proposed model for Capitalism 2.0.]

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