Over the past decades, capitalism hasn’t particularly enjoyed a good reputation. But are the claims justified? As we’ll see, capitalism is at the source of many structural issues in today’s society. However, it also accelerated human progress by providing incentives for solving human problems. But rather than turning our backs on the system, we can challenge some of the fundamental ideas that underpin modern-day capitalistic thinking. In this three-part series, we dive deeper into how we can turn 21st century capitalism into a force for good by first reassessing some assumptions our models are built on. Then we’ll explore several ways countless pioneers are already actively working on gearing up capitalism for social impact. By seeing the systems in which we live and ought to thrive through a holistic, wide-angle lens, and by focussing on impact first, we can create a better and more sustainable world for generations to come.
There is no escaping to the fact that capitalism is at the source of many structural issues in today’s society. The continuous focus on near-term, financial goals, as well as the endless pursuit of shareholder value maximization, has resulted in harmful, irreversible consequences on people and the planet. One such blatant issue was the 2008 financial crisis which clearly exposed the flaws in our financial system and the poor understanding of the economic dynamics at play.
Another issue often devoted to capitalism is income inequality. The modern-day cradle of capitalism, the United States, has seen a steep increase in income inequality since the 1980s. From 1979 onwards, the richest 1% in the US has become substantially richer (they enjoyed an average annual income growth of about 6%) while the incomes of the poorest haven’t grown for over 34 years. Importantly, rapidly growing income inequality isn’t a universal phenomenon. Although continental Europe also experienced an increase in inequality, the bottom 50% saw their pre-tax income increase by 40% over the last 3 decades. And what about global income inequality? Over the last 40 years, the incomes of the poorer half of the world’s population have risen faster than those of the richer half, resulting in falling global income inequality.
So the question here is not if capitalism produces inequality but how inequality arising from capitalism could be redistributed more equally. The reality teaches us that in shaping economic inequality, institutional and political forces play a central role.
Another major issue with capitalism is the so-called “negative externalities”. Externalities “occur in an economy when the production or consumption of a specific good or service impacts a third party that is not directly related to the production or consumption of that good or service.” More on this shortly.
That is not to say that capitalism hasn’t contributed to humanity’s well-being. Before the Industrial Revolution, at the dawn of the 19th century, no country in the world had a life expectancy longer than 40 years and almost everyone (95%) lived in what today would be considered extreme poverty (less than $1.90 a day).
Fortunately, this poignant depiction is nothing but a mere remnant from a history long bygone. A person born today, regardless of their country of birth, can expect to live as long as someone who lived in one of the richest countries in 1950. What’s more, the average person on the planet today is as rich as the average person in the richest country in 1950, and ‘just’ 1 in 10 people live in extreme poverty (earning less than $1.90 a day).
Besides getting richer, we’re also well on the way to becoming immortal. The UN estimates the average global life expectancy is 72.6 years; almost twice as long as only 200 years ago. Smallpox, an infectious disease that killed more than 300 million people in the 20th century alone, is the first ever human disease to be eradicated. This striking improvement was thanks to British surgeon Edward Jenner, who pioneered the first ever vaccination against an infectious disease, and the World Health Organization, which in 1957 set the ambitious goal of eradicating the disease globally (the last infection occurred in 1977 in Somalia).
Although we still have a long way to go to ensure everyone has a prosperous, healthy and fulfilling life devoid of poverty, hunger, and illness, we must be proud of the astonishing progress we have already made as a global society.
The far-reaching improvements in the human condition observed since the early 19th century can largely be explained by a radical shift in the prevailing notion of how the world works and how its members can best lead their lives. Born was a progressive intellectual movement that questioned the deeply held beliefs and values which were previously stored in a sacred box, tightly secured by the lock of dogma: The Enlightenment. In a 1784 essay “What is enlightenment?” Immanuel Kant wrote “Enlightenment is man’s emergence from his self-incurred immaturity (Unmündigkeit)” arguing that “the immaturity is self-inflicted not from a lack of understanding, but from the lack of courage to use one’s reason, intellect, and wisdom without the guidance of another.”
Minds freed from religious dogma started to see people’s problems no longer as part of the immutable human condition or as a fierce punishment of God, but as scientifically explainable challenges for which solutions could be found. And while unraveling humanity’s biggest mysteries, we also figured out a way to make plenty of money off them. And that’s when capitalism saw the light.
In other words, we could argue that capitalism has grown out of the recognition that enormous private wealth can be amassed by providing solutions to human problems. In a recent article, economist Eric Beinhocker and venture capitalist Nick Hanauer argue that “the genius of capitalism is that it both creates incentives for solving human problems and makes those solutions widely available.”
The invention of the automobile solved one of the greatest problems of its time. Mobilized transportation allowed people to move around quicker and easier than ever before. Rising demand for and the subsequent mass production of cars meant that motoring was no longer an exclusivity for the super rich. Soon, cars became a widely available commodity. And as a result, more and more roads were constructed to accommodate the West’s new favorite Sunday outing.
But what about the other side of the picture? Building new roads to meet increasing mobility comes at the expense of natural ecosystems and the people who depend on them. More cars also mean more carbon emissions and consequently, higher levels of air pollution which in turn contribute to global warming.
Capitalism holds the power to solve human problems on a large scale. But how does one justify the myriad of problems that are simultaneously created elsewhere, for others or for future generations? Let’s start by looking at the traditional economist’s approach to solving this issue.
Imagine the following situation. If I were to throw a plastic bottle over my neighbor’s hedge once, he probably wouldn’t notice, let alone suspect I did it. I’m happy, I just got rid of my waste with minimal effort and at no cost. The second time will arouse suspicion, and he’ll be on guard. When the next day I toss yet another bottle in his garden while he’s quietly enjoying his morning coffee, he’ll be quick to notice it was me, at this point making a confrontation inevitable. Failing to recognize the wider implications of my actions will ultimately backfire and cause harm to the broader environment in which I operate. Seems rather logical, right?
However, the outdated 20th century economic models we’re using today teach us that, under certain conditions, annoying our neighbors with our waste is fine. Economists even coined a term for it: ‘negative externalities’. Again, an externality is defined as ‘a cost (or benefit) that affects a third party who did not choose to incur that cost (or benefit)’.
Consider the following classic example. A pollutant factory discharges hazardous toxins into a river to cut costs which simultaneously affects the neighboring communities living down-stream. How would a traditional economist react? He would propose policy actions that would lead to the internalization of indirect costs by imposing taxes on externality-producing activities (i.e. discharging toxins). Dumping toxic effluents in a river at the expense of society is fine, but it comes at a price.
However, this way of thinking has several implications. First is the realization that any polluting company driven by cost reduction and profit maximization will try to externalize as many costs as possible. For example, if the cost for internalizing externalities is too high, the polluter can decide to offshore its polluting production to a nation with less restrictive environmental regulations. This would only move the problem, not solve it.
A second implication arises when a price tag is put on the negative externalities (or side-effects) of harmful business activities. How do you effectively determine the cost of such side-effects? Can any monetary value really make up for the damage caused to society and the environment? And what if the committed damage has irreversible consequences, like the extinction of a species?
And what about the wider, global implications of our actions and inactions? Deforestation of the Amazon rainforest for soybean cultivation damages the natural habitat of the thousands of species that depend on it for their survival. But the preservation of the Earth’s lungs is also imperative for our own survival and well-being. In today’s globalized economy, no individual or organization operates within a vacuum, invincible to long-lived outcomes of their actions.
Many economists have therefore suggested dropping the notion of externalities after all. The systems dynamics expert John Sterman argues that ‘there are no side-effects—just effects. Those we expected or that prove beneficial we call the main effects and claim credit. Those that undercut our policies and cause harm we claim to be side effects, hoping to excuse the failure of our intervention.’ He goes on by saying that: “‘Side effects’ are not a feature of reality but a sign that the boundaries of our mental models are too narrow, our time horizons too short.”
Let’s zoom in closer on the concept of mental models and why they matter.
Every day, we’re exposed to thousands of details that tell us something about the world. But humans are limited in their power to observe this abundance of details and our brains incapable of processing and storing all of them. That’s why we subconsciously draw on a mental model: the cognitive filter that meticulously selects the information that seems most important to us and keeps superfluous data out of the picture. In other words, a mental model determines where we direct our attention to – what we see, and what we ignore.
A good example of how the mental models we carry in our minds determine how we perceive and interpret a given concept is provided by Farnam Street:
When a botanist looks at a forest they may focus on the ecosystem, an environmentalist sees the impact of climate change, a forestry engineer the state of the tree growth, a business person the value of the land. None are wrong, but neither are any of them able to describe the full scope of the forest.
The knowledge you have acquired and the experiences you have lived shape the mental model you use to make sense of the world around you. Taking a specialist view can provide deep insight into one or several features of a forest, but if we want to fully understand the notion of a forest in all its magnitude and complexity, we must take a holistic view. By expanding the boundaries of existing and adopting new mental models, we are better able to understand the complexity and interconnectedness of the broader systems (be it a forest, an economy, or a galaxy) in which we live and thrive.
As we saw earlier, the Enlightenment and the progress that ensued were the result of a change in the prevailing mental model of how the world works: the belief that we live under universal physical laws replaced conventional superstitious dogma. As people’s understanding of reality expanded, so did the mental models that conceived it.
Likewise, our improved understanding of the global economy has urged us to revise our economic mental models. It’s time to drop the narrow-minded, reductionist model that dominated 20th century economic thinking. Market failures, like externalities, are the product of oversimplifying the complexity of consumer behavior and the market systems at work.
The mental models we use today should be a reflection of how we want to see the world tomorrow.
Humans use mental models to easier understand the complexity of the systems around them. Thanks to the progressive Enlightenment thinkers who challenged the prevalent mental models of their time, we can now state with gratitude and confidence that we are living in a more prosperous, healthier, and safer era than ever before.
However, the world in all its complexity and dynamism changes rapidly. And so should the mental models making sense of it all. Globalization has made it easier for us to see that what we once considered externalities or ‘side-effects’ of our economic activities has turned into defining social and environmental disasters. This seriously threatens capitalism’s premise as an accelerator for human problem-solving. To restore its credibility, we must adopt a holistic mindset and start by recognizing the broader impact of our actions and business activities.
In the second part of this series, we take a closer look at how we can think in terms of systems, rather than mechanisms, to guide our business activities. And how taking a broad perspective on impact from day one ensures that while solving the problems of some people, we avoid creating different problems for others or elsewhere. Welcome to our world of Impact Thinking.