Markets do what planning can’t; allow us to figure out how best to combine the economy’s various capital goods to serve human wants.

The Use of Capital in Society

Steven Horwitz is Economics Editor at Lib​er​tar​i​an​ism​.org and Distinguished Professor of Free Enterprise at Ball State University. Horwitz has written extensively on Austrian economics, Hayekian political economy, monetary theory and history, and macroeconomics.

At the start of my courses on Comparative Economics, I tell the students that I am going to try to avoid using the words “capitalism” and “socialism” for the duration of the semester. It’s a promise I obviously cannot keep, but I make that statement for a particular purpose. Those two words cause a lot of misunderstanding in conversations about economic systems. One of the reasons is that both words were coined by capitalism’s critics. As a result, the words themselves can bring a certain bias into the conversation. Both words imply a story about what is at the center of each system and who thereby are the major beneficiaries of each. The word “capitalism” suggests a system in which power rests with capital and in which the owners of capital are the prime beneficiaries. “Socialism,” by contrast, suggests a system in which power rests with society as a whole, with all of its members being the primary beneficiaries. The attraction that socialism has to many young people today, and their dislike of the word capitalism, might well be connected to the rhetoric implicit in those terms.

Let’s put aside for the moment the historical reality that the implied beneficiaries of each system have in fact been precisely the opposite of what the names suggest: capitalism has benefitted society as a whole in incredible ways and really‐​existing socialism ended up benefiting primarily a select few who had access to political power. When I teach this material, I tell the students that I’d much rather use the terms “market” and “planning” as they seem less ideologically loaded and because they describe the actual institutional processes at work in each system. And I’ve argued elsewhere that libertarians should seriously consider ditching the word “capitalism” for these and other reasons. All of that said, in this essay I want to make what I think is the best argument for why the word “capitalism” might be the right word to describe the liberal market economy. That argument has everything to do with the role of capital in solving the economic problems that every society must face.

The core problems that every society must face, thanks to the omnipresence of scarcity, are “what do people want?” and “how do we produce it using the least valuable scarce resources possible?” The first question is important, but the second question is the one that is frequently overlooked in debates over capitalism and socialism. Let’s call it, with apologies to Hayek, the problem of “the use of capital in society.”

One way of framing the problem that the use of capital in society raises is as follows. Every good or service that people might wish to consume can be produced using a variety of input combinations. There are multiple “recipes” for producing any given good or service. In addition, every input we have at our disposal can be used to produce multiple different goods and services. The problem of the use of capital in society is how to decide which input recipe to use for any given output and how to decide which output(s) to make from any given input. Even if you know you want to build a bridge, should you build it out of wood, steel, or concrete, or which combination thereof? And if you have a bunch of steel in front of you, should you use it for a bridge, a skyscraper, or a football stadium? Notice that these are not “engineering” or “technological” problems. Answering these questions has to confront the idea of value. Which way of building a bridge uses the least valuable resources (notice that “gold” wasn’t on the list), and which use of steel represents the most value created for society? The economic problem is best conceived as figuring out which among the technologically possible ways of producing things are the most economically efficient, i.e., use up the least valuable resources. In other words, we must constantly decide and re‐​decide how to use capital in society.

The word “capital” is one of the more contested terms in the history of economics. In general, it refers to the inputs that we use in creating outputs. The more precise term here would be “capital goods,” where “goods” includes what economists call “human capital” or the productive powers of labor. As I argued earlier, every society has to have a process by which it decides not just what to make but how to make it. That is, it has to have a process for determining the use of capital. If capital goods each had only one use or could be used for an infinite variety of purposes, then we would not face this problem. Either we couldn’t choose, or we wouldn’t have to choose. But, in fact, capital goods are, as Austrian economists say, heterogenous in use. Almost all inputs have at least one use but less than an infinite number. This requires that we choose how best to deploy them.

The problem of the use of capital in society is at the heart of the socialist calculation debate of the early 20th century. Marx and Marxian socialists argued that a fully planned economy without money, prices, markets, exchange, and private property, particularly in the means of production (capital), would be both more rational and more just than would the anarchy of production under capitalism. Planning could allocate resources more rationally and thus be more productive than capitalism. In 1920, Ludwig von Mises responded that there was no way to know if resources were being used rationally under socialism because it lacked a means of comparing the alternative uses of resources. There was no universal medium through which the value of goods could be compared. After showing why measures of labor could not work, he argued that money prices, resulting from the exchange of private property in the means of production, were the only way in which such comparisons could be made and thereby ensure the rational use of resources. It was impossible, he argued, for the planned economy of socialism to come anywhere near exceeding the prosperity created by capitalism. The rational allocation of resources required private property in the means of production which allowed for rivalrous competition among multiple owners and the emergence of money prices as “aids to the mind” for calculating prospective revenues and costs, and profits and losses. Without private property in capital, neither markets nor exchange were possible, and without them, there could be no money prices as the basis for comparisons of value. In a world of collective ownership of the means of production, socialist planners would stumble around in the dark.

From this perspective, capital really is at the heart of capitalism, though not in the way that critics like Marx believed. The centrality of capital does not mean that it is the owners of capital who are the primary beneficiaries of the system. Rather, it makes some sense to call the system “capitalism” because it has an answer for the challenge of the use of capital in society. Private property in the means of production enables the emergence of exchange, markets, and prices, and the latter enable us to determine how to best use capital goods. What Mises argued in 1920, and was expanded upon by later scholars like Hayek and Don Lavoie, was that socialism and other forms of economic planning lacked such a process. Our ability to use prices to make decisions about how to use capital goods and the role played by profits and losses in informing us after the fact about whether we did it well has no counterpart in socialism. Planning has no way of knowing how well it is using its capital goods.

This is also why Mises argued that nothing was more fundamental to a capitalist economy than capital markets and money markets. It is there that “these financial transactions of promoters and speculators…direct production into those channels in which it satisfies the most urgent wants of the consumers in the best possible way.” The shares of stock that change hands every day, and the changes in prices they cause, are what determine the use of capital in society as actors attempt to discern how best to provide the goods that consumers want. What distinguishes capitalism is a set of organized institutions that are capable of addressing this problem of capital use reasonably well. If you want to know whether an economy is capitalist, look to see if it has a stock market where ownership of capital is contested and where the uses of capital are decided.

One other observation about this whole line of argument is about the nature of capital and capital goods. Recall that the necessity of choice with respect to capital is because of what Austrian school economists call its heterogeneity in use. Austrians have always emphasized the ways in which capital goods have “multiple specificity” and can be used for multiple, though limited, purposes. This is in contrast to other approaches to capital within economics. Those perspectives on capital often treated it as an undifferentiated mass, much like soup in a tureen that can be ladled out and applied to any number of outputs. Whether it was Frank Knight’s “Crusonia plant,” or Paul Samuelson’s “shmoo,” or the “k” in modern production functions, these views of capital as homogeneous aggregates have obscured the problem of the use of capital that comes to the forefront with the Austrian view.

The use of capital is not a matter of doling out identical units of some aggregate of capital or investment. As Peter Boettke has argued, capital goods are not like Play‐​Doh that can be formed into any shape we want. They are more like Legos, where the pieces are different and can only be combined in certain ways. Or as Don Boudreaux and I have put it, using capital is like fitting together pieces of a jigsaw puzzle. Making capital goods fit together properly so as to best satisfy consumer wants will only be seen as the relevant challenge if one’s theory of capital allows for that heterogeneity in use. It is not coincidental that it was the Austrians like Mises and Hayek who criticized socialist planning for not having a way to ensure the effective use of capital in society. It was their own Austrian theory of capital that enabled them to see the problem that needed to be solved and how private property in the means of production could solve it.

Marxists are not wrong in recognizing that the market economy is centered around capital, and thus might aptly be termed “capitalism.” If there’s a case for capitalism’s defenders keeping that name, it will have to involve clarifying exactly what the central role for capital is and why it matters so much. It is not because capitalism primarily benefits the owners of capital. To the contrary, it’s the consumers who benefit. Rather, calling the market economy “capitalism” makes sense because only an economic system with private property in capital can solve the problem of the use of capital in society.