This article is an excerpt from the foreword to the new book What Adam Smith Knew (Encounter, 2014).

Each generation in a democratic society must make decisions about the proper boundary between individual choice and collective responsibility. The degree of freedom and equality in a given society will follow from the kind of economic and social model it applies: free-market capitalism, a socialist system, or a kind of welfare-state hybrid.

Each of these systems is made by humans, and therefore each is imperfect. As the medieval Christians believed and the great German philosopher Immanuel Kant said so well, “Out of timber so crooked as that from which man is made, nothing entirely straight can be carved.” Humans may create utopian systems on paper, but their plans cannot translate flawlessly into practice. Socialism is the product of Karl Marx’s thinking that an ideal society could be achieved if all capital were owned collectively—in practice, it would be owned by the state. This idea garnered widespread enthusiasm in the past. Socialism in reality, however, has generally brought low economic growth and reduced personal freedom, often with imprisonment or death sentences for opponents of the system.

A key reason for the wide discrepancy between the promise of socialism and its actual performance is that utopian schemes reduce human beings to abstractions. People are treated as members of a group or social class—workers, capitalists, peasants, or farmers. Individuals are assumed to be identical representatives of the group, wanting exactly what the group is expected to want. But human motives in the real world do not conform to such rigid patterns.

Capitalism, in contrast, acknowledges and accommodates human differences. Heterogeneous individuals, not homogeneous groups, are the building blocks of a properly functioning capitalist system. Capitalism does not offer a utopian vision of a perfect society, free of conflict. Instead, it offers something more attainable: economic growth and individual freedom under the rule of law. A perennial criticism of capitalism is that it produces vastly unequal living standards between the richest few and everyone else, but a democratic government joined to a capitalist economy provides a way of combining some income redistribution with freedom, growth, and the rule of law.

The redistributive social-welfare state has gained in favor as the manifest failures of socialist systems in practice have diminished support for that model. Few people now call for public ownership of the means of production as a way of increasing benefits for all or most of the citizens. Advocates of public ownership can still be found when it comes to public education, or the aim of establishing a single-payer national health-care policy; but public ownership of the steel or auto industry, for example, is no longer as attractive as it once seemed. Competitive enterprise has proved to be a much more efficient way to produce goods and services.

Socialists have therefore generally become proponents of an expanded welfare state attached to a system of competitive enterprise. Ownership of capital and the means of production remains mostly private, with some variation by country. Instead of owning all productive assets, the state taxes both labor and capital incomes. By making a claim on income from capital, the welfare state benefits from private capital without owning the capital or managing the assets.

In most developed countries today, the welfare state uses its tax revenue to finance a redistribution of income and wealth. The beneficiaries of this redistribution have ample reason to vote for more of the same, thus maintaining and often extending the social-welfare state. At the same time, however, the high tax rates imposed to fund this redistribution result in slower economic growth. These dynamics give rise to the central political issue of modern politics: voters must choose whether they want more consumption now, funded by redistributive policies, or lower tax rates to spur economic growth and generate higher future income and allow more future consumption.



Allan H. Meltzer is the Allan Meltzer University Professor of Political Economy at Carnegie Mellon University, Distinguished Visiting Fellow of the Hoover Institution, and author of A History of the Federal Reserve (University of Chicago Press, 2003 and 2009).