Practical analysis for investment professionals
25 October 2021

Modern Variants of Capitalism, Part 1: Classical Capitalism and Shareholder Capitalism

Capitalism is the economic system most advanced nations have adopted to foster growth and prosperity. Its Marxian definition, describing the principles of wealth accumulation through the appropriation of profits, certainly has many flavors. But all imply that private ownership and free enterprise are key inputs.

The methods of wealth creation mutated over time, proving their remarkable plasticity. Today, capitalism knows four configurations: two inherited and adapted from previous eras and explored here, and two that emerged more recently through deregulation and disruption and covered in subsequent articles.

Far from being mutually exclusive, these variants often operate in tandem.

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Variant 1: Classical Capitalism — An Institutionalized Model

Capitalism’s diversity is not a static occurrence: It results from a dynamic entanglement of development processes often described as creative destruction.

As the system evolved, so did the operating and profit-making model of corporations.

Mercantilism emerged through the internationalization of trade routes in the 16th century and relied on coerced labor as well as imperialist, protectionist, and monopolistic principles. In 1600, for instance, the London East India Company was granted a monopoly on any trade to the east of the Cape of Good Hope, marking the beginnings of merchant capitalism.

Industrial capitalism took shape thereon. Its institutionalized version resulted from socioeconomic modernization and technological improvements as well as legal advancements. And it contrasted with merchant capitalism in that state intervention was replaced with private initiative.

The system was fed by the Industrial Revolution in the 18th century. The interactions between its four main protagonists — landlords, merchants, industrialists, and workers — are illustrated in the graphic below.

Riches accrued to the landlords, the factory and mine owners, and the merchants. The output produced by the workers had to be sufficient to serve the interests of those in effective control of capital. In turn, capitalists had one core objective: wealth accumulation.

Merchant bankers like the Barings and Rothschilds and financier George Peabody in the 18th and 19th centuries lent their own money to speed up the process.


Classical Capitalism: The Main Protagonists

Chart showing Classical Capitalism: The Main Protagonists

The Classical Model of Value Creation

In a classical, principally industrial capitalist system, superior returns are generated as follows:

  1. Capital is accumulated through the use of the means of production and the employment of a salaried workforce. In the mining industry, natural resources are also relentlessly exploited.
  2. Most accumulated wealth stays in the business through reinvestment and capital reserves, as depicted in the following chart.
  3. A portion of capital leaks out as dividend distributions. Wealth is optimized when such leakage is minimal or, ideally, nonexistent. The capital owner must prevent cash from leaving the business. This principle explains the prevalence of tax avoidance today.
  4. This growth model is essentially organic. Industrialists achieve economies of scale by acquiring customers, entering new markets, and launching new product lines. Innovation, research and development, and horizontal consolidation are the key tools to enhance value.
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Capital could accrue to the owners upon disposal of the business, but many industrialists in this model are long-term and often lifetime owners. For private businesses, retained earnings are the main source of funding; borrowing capital is secondary.

This was the economic environment in Adam Smith’s days and for most of the 19th century. It culminated in the era of the industrial trusts, with Andrew Carnegie and John D. Rockefeller heralding the age of Big Steel and Big Oil.


Shareholder Value Creation in an Industrial Capitalist Model

Chart showing Shareholder Value Creation in an Industrial Capitalist Model

The Classical Model’s Modern Incarnation

So what sort of corporations apply this model today? Technology firms, particularly gig economy companies, are prime examples. Gig workers have, in many instances, as few protections as laborers in 19th-century factories: Many lack employment contracts, paid holidays, medical coverage, or company-supported retirement plans. For the start-up business model, such arrangements help reduce operating costs, albeit with many negative spillovers, including job instability and social inequality.

Remote work and the expanding use of personal vehicles by self-employed delivery drivers — the “grey fleet” in the United Kingdom — are also reminiscent of an earlier, classical era. In the 18th century, artisans often worked from home on a freelance basis. Some used their own equipment to complete tasks subcontracted by a manufacturer as part of the division of labor. Compelling economies of scale eventually brought teams of workers under one roof.

Some delivery platforms now lease bikes and automobiles to their workers just as 19th-century corporations lent production tools to craftsmen so they could work from home.

Although, as this series will demonstrate, the classical capitalist model has lost ground to more dynamic variants, it is still very much alive. The expansion of the on-demand economy means that more and more workers are on tap, to be called upon by employers as and when needed, freelancing on zero-hour contracts, and available at a moment’s notice.

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Variant 2: Shareholder Capitalism — An Intermediated Model

Starting in the late 19th century, during the so-called Second Industrial Revolution, corporate financiers like John Pierpont Morgan, rather than just extending loans, recycled their own capital to take equity stakes in their clients’ industrial concerns.

J.P. Morgan coordinated the consolidation of the rail system in the 1880s. An early backer of inventor Thomas Edison, he engineered the creation of General Electric by combining Edison General Electric in New York with Thomson-Houston Electric in Massachusetts in 1892. Nine years later, he financed the merger of Carnegie Steel with two of its rivals to form US Steel.

It wasn’t until the early 20th century that merchant bankers and other financial firms became the primary lenders and investors of other people’s money.

Uber-Intermediation

An important factor behind this evolutionary step of capitalist economies was the separation between corporate managers and corporate owners. In the 1900s for instance, Andrew Carnegie no longer managed his steel empire: It was run by his business associate Henry Clay Frick.

Three years after the Great Crash of 1929, Adolf Berle and Gardiner Means published The Modern Corporation and Private Property, emphasizing what soon became the norm for US companies other than founder- or family-run enterprises. Shareholders did not manage the business, expert custodians did.

Corporate executives became the focus of management consultants in books like Peter Drucker’s Concept of the Corporation about General Motors. Leadership was passed on to professional managers, or what John Kenneth Galbraith called the “technostructure.”

Another step in the evolution of modern economies took place in the late 19th and early 20th century. Not only were corporations not run by their owners, but shareholders no longer administered their own wealth. Gradually, they started to receive advice from a new breed of financiers that today we call asset or fund managers.

A century after Louis Brandeis’s essay collection Other People’s Money and How the Bankers Use It, managing third-party funds has now become big business.

Making money on the back of other people’s assets was nothing new. The Spaniards exploited the mines of Mexico and Peru in the late 15th and early 16th centuries. They then shipped the extracted silver and a fair amount of gold back to the Old World. The same rule applied to all the major European countries that siphoned riches from their colonies. As the 19th century Bengali novelist Bankim Chandra Chatterjee observed, “The English who came to India in those days were affected by an epidemic — stealing other people’s wealth.

In fact, every empire since antiquity operated that way. They all got rich on the back of others’ property. The key distinction with capitalism is that, in the imperialist system, the plucked out capital never had to be redeemed and no interest was due on it. It was expropriation, following the rules of mercantilism, not administration as in capitalism.

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Shareholder Value Creation Model

Shareholder capitalism’s modus operandi, as depicted in the chart below, consists of:

  1. Capital accumulation endogenous to the production apparatus, using labor as in the classical capitalist system, but also outside experts with technical knowledge.
  2. The larger proportion of built-up capital remains within the company through re-investments and reserves.
  3. Some capital originates exogenously, via equity rights and debt issuance, either for corporate activity like mergers and acquisitions or to accelerate organic growth.
  4. A portion of capital leaks out through dividend distribution and loan redemption. Capital is shared between internal executives and outside investors.
  5. Capital accretion is no longer exclusively derived from growth. Value can arise through operational improvements, whose purpose range from optimizing production methods to managing costs, ensuring quality control and more complex methods like process re-engineering. Taylorism and Fordism gained widespread acclaim and scientific pretense in the first half of the 20th century.

Value Creation in Shareholder Capitalism

Chart showing Value Creation in Shareholder Capitalism

The mainstay of this system is technical expertise. Most corporations gradually adopted it, blending internally produced wealth with capital raised from third parties.

Vertical integration in the 1920s and 1930s and the conglomeration trend from the 1960s onward were built on the principles of shareholder capitalism. That is when the system came of age. Think of General Electric, which bought and sold hundreds of businesses and obsessed over lean manufacturing and Six Sigma during Jack Welch’s tenure.

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The era of the “supermanager” gave birth to meritocracy, a concept that has come under growing criticism due to its social costs, as described in The Tyranny of Merit and The Meritocracy Trap.

The industrial and shareholder capitalist models were scrappy ways to make money. Many multinationals have since experienced serious deconglomeration. But the practices derived from these two models have not disappeared, they have been upgraded. Today’s empire builders — financiers like private capital fund managers, and tech monopolists — follow a more lucrative, systematic approach to value creation.

They will be the subject of the next entries in this series.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / duncan1890


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About the Author(s)
Sebastien Canderle

Sebastien Canderle is a private equity and venture capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books, including The Debt Trap and The Good, the Bad and the Ugly of Private Equity. Canderle also lectures on alternative investments at business schools. He is a fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from The Wharton School.

2 thoughts on “Modern Variants of Capitalism, Part 1: Classical Capitalism and Shareholder Capitalism”

  1. Leon HUNTER says:

    *Taxpayer capitalism* would be a fairer model. It is where the people who pay the most (i.e. SMEs) get more in return. But the model would require associations and pooling of those parties as – taken individually – they have less pressure power. It would also lead to less fraud and tax havens because if paying more translated into a greater share of services, power and benefits, there would be a greater willingness to pay.

  2. Kirk Cornwell says:

    The massive non-dividend paying (or nominal dividend-paying) corporations dominating the indices now suggest the continuation of a trend of accumulation of great wealth by the .1% and, collectively, the 10% who ‘play’. This is probably more consistent with history than we think. The question is how to solve our “declining society” problems (education, infrastructure, environment) in this context.

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