Milanovic, B. 2019. Capitalism, Alone: The Future of the System That Rules the World. Harvard University Press.

Chapter 2

Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Chapter 1 | Chapter 3 | Chapter 4 | Chapter 5

Chapter 2: Liberal Meritocratic Capitalism

Liberal meritocratic capitalism is a system where most products are manufactured by profit seeking privately owned means of production, capital hires free labor, and coordination is decentralized. Most investments are made by private companies or individual entrepreneurs. Careers are open to talent (meritoric), inheritance of property is fully accepted, and there is free education (liberal) to reduce the intergenerational transmission of advantages. However the system includes forces that influence income distribution that lead to the formation of an upper-class elite.

Key Features of Liberal Meritocratic Capitalism - Historical Capitalism

The following illustration compares Liberal Meritocratic Capitalism to two other historical types of capitalism that previously existed in Western economies. These include Classical Capitalism that developed in the UK before 1914, and Social-Democratic Capitalism that developed in the U.S. and Europe after World War II. The two main income classes include individuals that derive their income from capital, and those that derive their income from labor. The main distinction between the types of capitalism is whether these distinct classes of individuals overlap. Since the late twentieth century the percentage of capital income has been rising as a percentage of total income. This occurred in both classical and liberal meritocratic capitalism, but not in social-democratic capitalism, and it resulted in greater income inequality between individuals. The main difference between classical capitalism and liberal meritocratic capitalism is that now capital abundant individuals also receive a considerable amount of labor income as well as capital income. The rich were previously in the leisure class, but today people who are capital-rich also tend to be labor-rich, e.g., highly paid managers, web designers, physicians, investment bankers, or elite professionals. This increases the level of inequality and is a characteristic of liberal meritoric capitalism.

Marriage patterns are also important. After World War II many women did not work, but today richer and more educated men tend to marry richer more educated women who also work (i.e., assortative mating or homogamy). This also increases income inequality. Liberal meritocratic capitalism in the U.S. also includes a high intergenerational transmission of inequality as wealth and human capital are transferred across generations. Even so, inequality is much lower in liberal meritocratic capitalism than it was during the period of classical capitalism. In addition, these systemic inequality-enhancing features of liberal meritocratic capitalism are for the most part socially desirable, e.g., people can become rich by working, and there is a greater level of participation by women in the labor force.

Key Features of Liberal Meritocratic Capitalism - Systemic and Nonsystemic Causes of Increase in Inequality in Liberal Meritocratic Capitalism

It is important to note the differences between systemic and incidental features of liberal meritocratic capitalism so that we can focus on the systemic characteristics that define a system and how they might affect the system's evolution. For example, some nonsystemic or incidental features include the skill premium paid to skilled labor because of the shortage of supply of these workers and the technological change that made skilled labor more productive.

Systemic Inequalities - Increasing Aggregate Share of Capital in National Income

One reason for the increasing income inequality is that the share of income from labor began to decrease.  Labor's share of national income declined from around 67 percent in the 1970s to around 62 percent in 1910. This occurred for a variety of reasons including an increase in capital as low-skilled labor was replaced by technology, a decline in the relative bargaining power of labor versus capital, an increase in entrepreneurship (normally included with capital), and corporate outsourcing of services previously performed in house.

Systemic Inequalities - High Concentration of Capital Ownership

Wealth is more concentrated than income because wealth accumulates over time and is transferred within households and across generations and tends to grow exponentially. In 2013 the top 1 percent of wealth-holders in the U.S. owned one-half of all stocks and mutual funds, 55 percent of financial securities, 65 percent of financial trusts, and 63 percent of business equity. The top 10 percent owned more than 90 percent of all financial assets. Income from capital is much more unequally distributed than income from labor. This is a systemic feature of liberal meritocratic capitalism, i.e., capital income is extremely concentrated and is received mostly by the rich. This systemic feature or characteristic also applies to other capitalist countries. As capitalist countries become richer, the share of capital income increases and this causes inequality to also increase. Inequality will tend to increase as long as no additional policy measures are taken to offset the systemic forces pushing inequality.

Systemic Inequalities - Higher Rate of Return on the Assets of the Rich

The rich own more wealth and own different types of wealth than the rest of the population. In 2013, 20 percent of households in the U.S. had zero or negative wealth. The middle 60 percent of households had most of their wealth tied up in housing (2/3) and pension funds (16%). This wealth was highly leveraged, i.e., 80% was debt (mortgages) and undiversified. However, the assets of the top 20 percent of households are made up of equity and financial instruments with housing wealth a relatively low percentage of the total. Since financial assets out perform housing wealth, the composition of wealth is an important long-term contributor to greater inequality. In addition, the asset classes of the rich tend to be taxed less than the asset classes held by the middle class. The rich earn higher returns on their assets because they hold more assets whose long-term returns are higher, they pay less tax per dollar earned from wealth, and entry fees and management cost of their asset classes are lower than those of the middle class. The remedy would require progressive taxation.

Systemic Inequalities - Association of High Capital and High Labor Income in the Same Individuals

A unique feature of liberal meritocratic capitalism compared to classical capitalism is the increasing percentage of the population with high capital income combined with high labor income. In 1980 only 15 percent of people with high capital income also had high labor income. By 2017 that percentage had doubled. This adds to the level of inequality and makes it more difficult to develop economic policies to provide a solution (e.g., progressive tax) because income from labor is viewed as more deserved than income from capital.

Systemic Inequalities - Greater Homogamy (Assortative Mating)

Research shows an increase in homogamy, or that people of the same or similar education status and income level marry each other. In 1970, 13 percent of American men in the top decile of male earners married young women who were in the top decile of female earners. By 2017 that percentage rose to 29 percent. A similar change occurred for women. During this same time period the percentage of young women marrying top earning young men increased from 13.4 percent to 28.7 percent. There is also a link between this assortative mating and the increasing importance of early childhood learning that only more educated couples are able to provide. When educated highly skilled affluent people marry each other it tends to increase inequality. About one-third of the inequality in the U.S. between 1967 and 2007 can be explained by assortative mating. This would occur even if high taxation of inheritance were imposed on the rich.

Systemic Inequalities - Greater Transmission of Income and Wealth across Generations

High income and wealth inequality have been justified by claiming that everyone has the opportunity to achieve the American Dream regardless of family background. However, research shows a high correlation between high inequality and low income mobility. The implication is that the children of the rich have much greater opportunities compared to children of the poor. In addition, intergenerational mobility has been declining. During the 1980s three changes occurred simultaneously: inequality increased, the returns to education increased, and the correlation between parents' and children's incomes also increased across time. Higher income inequality and lower intergenerational mobility are closely related. In addition, the change in real income between generations declined between 1940 and the 2000s because of a decline in the rate of economic growth combined with increased inequality.

New Social Policies - Why Twentieth-Century Tools Cannot Be Used to Address Twenty-First Century Income Inequality

There was a period of reduced income and wealth inequalities in the U.S. and other countries from the end of World War II to the early 1980s. These reductions in inequalities were supported by strong trade unions, mass education, high taxes, and large government transfers. However, during the 1980s income inequality began to rise with a decline in trade union membership, smaller increases in average education levels, an increase in the mobility of capital caused by globalization, and less opportunity to maintain or increase taxation and social transfers. In the U.S., market income inequality (income from wages, property, and self-employed income), gross income inequality (market income plus social transfers), and disposable income inequality (gross income minus direct taxes) all increased during the period from 1974 to 2016.

National policies could affect the distribution of capital ownership using three methods. These include favorable tax policies to make equity ownership more attractive to middle class investors, increasing worker ownership by expanding employee stock ownership plans, and using a stronger wealth or inheritance tax. Wage inequality could be reduced by improving the quality of public schools with large investments in public education and the withdrawal of numerous advantages provided to private universities and secondary schools.

New Social Policies - The Welfare State in the Era of Globalization

The welfare state developed from the realization that most individuals experience periods when they have no income, or limited earnings, e.g., the young, the sick, the injured, and the elderly. However, the welfare state requires mass participation. The opportunity for some to opt out of the system makes it unsustainable. But globalization and trade have led to a decline in the relative income of the middle class and to an increase in the number of people at the two ends of the income distribution. This income polarization causes the rich to seek their own private systems for health care, education, and pensions. This means a polarized society cannot easily maintain an extensive welfare state. Economic migration can have a similar effect. When the number of low skill workers increases, this causes further polarization between the poor and the rich and encourages further privatization of social services.

New Social Policies - Self-Perpetuating Upper Class?

There is considerable evidence that the rich in the U.S. have a disproportionate influence on politics. The U.S. has evolved from being a democracy to an oligarchy or system where political power is derived from economic power or wealth. For example, members of the U.S. Congress are much more likely to vote on issues that are important to the rich than those that benefit the poor or middle class. The rich control the political process through funding the political parties and electoral campaigns. In 2016 the top 1/10 of 1 percent contributed 40 percent of the total campaign donations. What the rich get for their political contributions are economic policies that benefit them including for example, lower taxes on high incomes, tax deductions, higher capital gains through tax cuts to corporations, and fewer regulations. Political control is a requirement for the existence of a durable upper class.

The upper class is maintained through education and inherited wealth. The members of the upper class are better educated, they work harder, get a larger share of their income from labor, inherit more wealth, and tend to intermarry. They send their children to private kindergarten, primary and secondary schools, and use Legacy admissions to get their children into the best colleges. This reduces their willingness to pay taxes for public education and creates a system where a small group of top schools are attended mostly by the rich, and a large group of mediocre schools for everyone else. Better quality education and inherited wealth helps transfer the advantages of the rich to the next generation and reinforces their power.

Pareto defined two types of ruling classes, lions and foxes. Lions represent a ruling militarized class that maintains control through violent means. Foxes on the other hand avoid the use of violence and use economic power and other means to maintain control. The ruling class in liberal meritocratic capitalism is clearly made up of foxes. The characteristics of its upper class elite are summarized as follows:

 1. They control most of the financial capital of the country. In the U.S. the top 10 percent control 90 percent of the financial assets.

2. They are highly educated and receive high income from labor as well as income from capital.

3. They invest heavily in their children and in political control. The political influence of the elite allows them to control the rules of inheritance and together with the education advantage enables the reproduction of the ruling class.

4. Their investment in political control helps insure the dominance of the ruling class over time.

5. The ruling elite includes women and is probably the least gendered of all historical ruling classes.

6. Family formation of similarly educated and rich couples (homogamy) contributes to the intergenerational maintenance of these advantages.

7. The upper class is open to others and grows when the best members of the lower classes are able to become wealthy and highly educated.

8. The members of the ruling class are hard working and have an amoral outlook on life. Their advantages are obtained legally even though they increasingly diverge from general ethical standards.

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Go to the next Chapter. Chapter 3: Political Capitalism

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Buchanan, M. 2002. Wealth happens. Harvard Business Review (April): 49-54. (Buchanan describes a universal law of wealth based on a network effect that appears to have some important implications for economic policy). (Note).

Graham, J. L. and N. M. Lam. 2003. The Chinese negotiation. Harvard Business Review (October): 82-91. (How to deal with China. Understand the cultural context of Chinese business style). (Summary).

Ignatius, A. 2021. "Americans don't know how capitalist China is." Harvard Business Review (May/June): 61-63. (Summary).

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