Democratic capitalism is a system that marries liberal democracy and free-market capitalism. This union creates tensions, and requires balancing competing aims. But this tension is healthy, not destructive — provided that democracy and capitalism are properly balanced, each sphere reinforces the other. Over the long term, capitalism requires liberal politics; and democracy will not maintain legitimacy without the prosperity that requires free markets.

Under democratic capitalism, the political system should interfere with markets as little as possible, only intervening for necessary regulation, to correct market externalities, and to raise revenue for public programs. Of course, market outcomes are not always socially desirable, as determined by citizens through the democratic process. Democratic capitalism allows for government to redistribute income and to provide services to adjust market outcomes. But, when the marriage is healthy, public policy must be conducted with the phrase “do no harm” — read “do as little harm as possible” — to the creativity, innovation, and dynamism that power long-term prosperity in mind.

And free markets must deliver the jobs, wage growth, and long-term prosperity that lead to widespread support for liberal democracy and the rule of law, and that allow for relative social cohesion and harmony.

With that in mind, what is the current state of democratic capitalism?

The economy is certainly holding up its part of the bargain:

• The average wage has never been higher. Throughout the labor market, average hourly earnings across all workers were $35.36 in September 2024, higher than it has ever been. For manufacturing production workers, construction workers, and non-supervisory workers in the service sector — roughly speaking, a group we can think of as workers who aren’t managers — the average wage was $30.33. And after adjusting for inflation, wages for typical workers are also at record highs.
• Wages have been growing robustly for workers of all education levels.
• Median household income has never been higher. At $80,610 in 2023 (the most recent year for which data are available), nominal median household income more than doubled over the past 25 years. Because of the high rate of consumer price inflation of recent years — more on that topic in a moment — real median household income declined over the last few years. But in 2023, it resumed rising, and is within spitting distance of its 2019 high.
• Over eight in 10 adults between the ages of 25 and 54 — roughly speaking, adults who are too old to be in school and too young to be retired — were employed in September. At 80.9 percent, the employment rate is higher than at any time since March 2001, shortly after the employment rate hit its peak of 81.9 percent in April 2000.
• Everyone who wants a job can get a job. The unemployment rate remains very low — well under the rate at which most economists and Federal Reserve policymakers believe is sustainable over the longer term.
• In today’s labor market, businesses are chasing workers rather than workers chasing jobs. There are more job openings than unemployed workers.

As these indicators highlight, the strength of the economy is undeniable. This is all the more remarkable given the period of four-decade-high inflation the U.S. recently endured.

That inflationary episode can be understood through the lens of democratic capitalism as a failure of the political system to respect the proper functioning of the economy. The American Rescue Plan — the pandemic stimulus bill signed into law by President Biden in March 2021 — stimulated the demand for goods and services well beyond the economy’s productive capacity.

While the inflation of 2021-2023 had many causes, including shocks to the supply side of the economy, most of the surge in the rate of price increases came from excessive demand, fueled in large part by excessive fiscal stimulus — by politicians overweighting the (perceived) political benefits of stimulus programs and underweighting the risks they were imposing on the economy.

Due to this severe imbalance between aggregate demand and supply, the Federal Reserve had to increase by over 4.5 percentage points in just one year, from near zero percent in March 2022 to 4.8 percent in March 2023. The Fed increased the rate all the way to 5.3 percent in the summer of 2023, and kept it at that high level until this fall.

Because the Fed’s policy interest rate was so high, the interest rates on home mortgages, credit cards, and business loans all shot up. This created the widespread expectation that the economy would fall into recession in 2023. If that had happened, it would have been an even bigger failure of democratic capitalism — the story would have been that the political system did not have adequate respect for the sound economic policy, and an increase in the unemployment rate was required to undo the damage.

It is a great thing that the economy avoided recession, but that should not absolve Congress and President Biden from the reckless fiscal policy they pursued in 2021. Economists — including me — were wrong about a recession in 2021 because of several developments that were difficult to forecast:  A large surge in immigration kept the labor market cooler than it would have been, allowing the Fed to avoid even higher interest rates; the AI boom of 2023 sustained business investment and supported consumer spending in the face of high interest rates; and expectations of consumers and investors regarding future inflation remained remarkably well-anchored to the Fed’s inflation target.

It would be imprudent for policymakers to bank on similar developments in the future. Instead, they should learn from the inflation of the early 2020s that in our system of democratic capitalism, irresponsible fiscal policy has real economic consequences.

It has political consequences, as well. Voters have been very concerned about inflation and have poorly rated President Biden’s handling of the economy. President Biden’s weak poll numbers on economic management have transferred to Vice President Harris. At the time of this writing, the election day is a month away. If the vice president loses to Donald Trump, part of the blame will go to irresponsible fiscal policy and the four-decade-high inflation to which it contributed.

Industrial Policy: (Almost) Always a Bad Idea

A major threat to the health of democratic capitalism is the growing support for industrial policy in both political parties.

To be clear, industrial policy is not always bad, and is not something to be avoided in principle. In a recent paper for the Aspen Economic Strategy Group, I outline five criteria to help separate the industrial policy wheat from the chaff:

First, successful industrial policy has a clearly defined goal. Second, successful industrial policy should not attempt to balance multiple competing goals. Third, it should be a priori plausible that the policy will be achievable. Fourth, the policy should not be part of a partisan political agenda — it should have bipartisan support or be inherently nonpartisan. Finally, the broader ecosystem necessary for success — technological capability, workforce skills — should be in place before the policy is executed.

A recent example of successful industrial policy is Operation Warp Speed. Its goal was clear: the development, manufacture, and distribution of Covid-19 vaccines. It was not trying to achieve multiple, competing goals. When President Trump announced the program in May 2020, success was far from certain — but success was a plausible outcome. The development, manufacture, and distribution of Covid-19 vaccines was widely popular in both political parties. The U.S. had world-leading pharmaceutical companies — if any company was up to the job, they were. And the broader ecosystem was in place.

Operation Warp Speed was a huge success. Seven months after the program was announced, multiple new Covid-19 vaccines were authorized for use.

Operation Warp Speed was industrial policy: It was government intervention in the economy to override market outcomes with the goal of promoting a politically favored industry. But it was deployed responsible. And the increase in GDP that results from the policy far outweighed its cost to the taxpayer. It paid off.

In passing the CHIPS and Science Act and Inflation Reduction Act (IRA), President Biden broke with the decades-old bipartisan consensus against industrial policy by using it to reshape the composition of industry and of employment in the economy. These laws — especially the IRA — are not targeted interventions in the economy to achieve well-defined, narrow outcomes. Instead, they have expansive goals: To revive domestic manufacturing employment, advance and increase the domestic clean-energy sector, increase the “resilience,” and advance the U.S.’s strategic competition with China.

The goals are far from clear. How will we know when we have revived domestic manufacturing? How will we know when we produce enough of the world’s cutting-edge semiconductors to be sufficiently resilient? How will we know whether we have succeeded in slowing the pace of climate change? Importantly, what would constitute successfully passing a cost-benefit test for the taxpayer for any of these goals? What would constitute failure? And why?

The Biden administration’s industrial policies are at odds with each other. With one hand, the administration is trying to advance the use of electric vehicles; with the other, it is using large tariffs to stop Americans from buying electric vehicles made in China. With one had, the administration is trying to slow the pace of climate change; with the other hand, senior officials are trying to waive environmental regulations in order to accelerate the construction of semiconductor manufacturing facilities. The administration is spending taxpayer dollars on all these initiatives.

With respect to our third criteria, these policies are not plausibly achievable. The IRA will likely cost over $1 trillion, with CHIPS Act spending on top of that. It would be surprising if spending of this magnitude did not reallocate some jobs into manufacturing and away from other sectors. But they will not succeed in reviving domestic manufacturing in any meaningful sense. As I write in my AESG paper: “Even if these subsidies increased manufacturing employment by 50 percent — a huge increase — that would merely return the manufacturing employment share to its level from two decades ago, far from the golden era of manufacturing in the decades following the Second World War.

The IRA might succeed in catalyzing the development of clean energy technologies. But if it achieves this goal, we should be confident that it will be at much greater expense to the taxpayer, with much less economic efficiency, and with much greater damage to international alliances than a simple carbon tax or public funding for basic energy research. As for the CHIPS Act, allow me again to quote from my AESG paper:

Given the importance of semiconductors to a wide variety of products and the large share of their production located in Taiwan, the CHIPS Act is much more defensible than the IRA. It is also expected to have a fiscal cost two orders of magnitude less than the IRA’s. The CHIPS Act will likely see more semiconductor manufacturing in the US than would otherwise have been the case. But for resilience and national-security purposes, there is little reason to conclude that this activity needed to be moved to the United States at great expense to taxpayers.

The U.S. produced 12 percent of the world’s chips in 2020. A study commissioned by the Semiconductor Industry Association concludes that the CHIPS Act will lift this share to 14 percent in 2032. The study also finds that the U.S.’s production share of cutting-edge chips would rise from zero to 28 percent. Even if these optimistic forecasts come to pass, it is not clear whether these projected increases in U.S. production would materially advance either resilience or security. Is the U.S. qualitatively more resilient or secure if 72 percent, rather than 100 percent, of cutting-edge chips are produced in other nations?

Instead of industrial policy, safeguarding national security should involve identifying a narrow set of specific inputs and goods that genuinely warrant special attention by the government, and working with allies to ensure that their supply is diversified away from adversarial nations or geopolitical hotspots. Coordinating with allies would allow production to be relocated to nations

that are best situated to produce. It is a large leap from arguing that the supply of certain, select critical inputs and goods not be exposed to adversarial nations to arguing that their production should be located in the United States. Countering China with a coordinated coalition of allied trading partners would be much more productive than bursts of bilateral protectionism.

On the fourth criteria, the CHIPS Act has some bipartisan support, but the IRA does not. I am writing prior to the November election, but if President Trump wins it is likely that he will attempt to thwart the IRA, possibly even through legislative amendments. In that case, business plans would go up in smoke and the return on investment for the taxpayer would be even less.

Finally, companies receiving subsidies from these programs are running into serious challenges in effectively using them because the U.S. does not have a workforce trained to operate semiconductor factories. This, among several other factors, including those mentioned above, has led to substantial delays. A Financial Times investigation this summer found that around 40 percent of the CHIPS Act and IRA projects worth more than $100 million had been substantially delayed or paused indefinitely.

During the U.S.’s current bout of industrial-policy enthusiasm, all the old questions are worth asking again: Why would the government be better at picking winners and losers than the market? If the government tries to shape the industrial and employment composition of the economy by overriding market forces, how will it avoid mission creep, corruption, and cronyism? The Biden administration has awarded $8.5 billion to Intel. Why does Intel need billions of dollars of taxpayer (read: other people’s) money? Why is that a better use for taxpayer dollars then many other priorities?

Industrial policy is a threat to a healthy system of democratic capitalism for three reasons. First, in the marriage between liberal democracy and the free enterprise system, it is the role of markets to allocate resources and determine the composition of American industry and employment. When the government overrides markets, it slows economic growth and threatens long-term prosperity. By slowing productivity growth, wage growth, and the rate at which living standards rise, it also undermines support for liberal politics because democratic legitimacy stems in large part from strong economic performance.

Second, in a system of democratic capitalism, markets should determine the shape of the economy for a practical reason: market forces are better at that task than elected officials. When government substitutes political judgments for market forces, taxpayer dollars are used inefficiently. President Obama’s 2009 effort to protect domestic tire manufacturers from competition with Chinese imports is a good example (of many). His policy protected around 1,200 jobs at a cost to American consumers of $900,000 per job in 2011.

This was an inadvisable policy because, in an economic sense, the $1.1 billion cost incurred by consumers could have been put to a higher use. It is an inadvisable policy in a political sense because it erodes confidence in government.

Finally, industrial policy infringes on economic liberty by the government places an (at times, heavy) finger on the scale of private economic transactions. Economic liberty is not sacrosanct, of course, and there are many good reasons for it to be violated in a democratic-capitalist system. But the freedom to engage in commercial transactions without government interference should be the default position in a free society. Free markets use the voluntary cooperation and choices of millions of workers, households and businesses each day to coordinate economic activity and shape economic outcomes, free from coercion. The more the government is involved in determining the nation’s industrial and employment composition, the larger its scope and scale. This becomes a threat not just to economic liberty, but to political liberty as well.

The Deficit is a Threat to Democratic Capitalism

In addition to growing bipartisan support for industrial policy, a second major threat to democratic capitalism is the ballooning national debt.

America’s fiscal outlook is deeply troubling. In the 1980s and 1990s, the amount of U.S. public debt was around 39 percent of annual GDP. By 2010, the debt had grown to around 61 percent of GDP. The nonpartisan Congressional Budget Office projects that the national debt will keep growing over the coming decades. Next year, CBO expects the size of the debt to equal the amount of output produced by the economy. By 2034 — only ten years from now — CBO expects the debt to rise to 122 percent of GDP.

While it is the case that Presidents George W. Bush and Donald Trump substantially reduced the level of tax revenue through their tax cuts, the growth in the projected national debt is a properly thought of as a spending problem. The reason for this is simple: Spending is projected to grow over the coming decades, while revenue is not projected to decline.

In fact, the opposite is true. Over the past half century, the amount of tax revenue collected by the government has averaged 17.3 percent of annual GDP. Over the next decade, the CBO expects that tax revenue will be slightly higher than its historic average, rising to 18 percent of GDP. CBO projects government spending to rise from its historic average of 21 percent of GDP to nearly 25 percent of GDP by 2034.

This makes clear: The U.S. has a spending problem, not a revenue problem. Of course, more revenue would reduce the budget deficit. But increased revenue would only shrink the level of the deficit. Because the trend of rising deficits (and, therefore, accumulating debt) is driven by spending that is projected to increase, more revenue doesn’t change the long-term budget outlook. According to the Committee for a Responsible Federal Budget’s debt model, fully repealing the 2017 tax cuts, along with increasing taxes on capital income, would reduce the expected debt-to-GDP ratio in 2050 by only three percentage points, from 160% to 157%.

Despite these projections, neither Vice President Harris nor President Trump want to discuss the U.S.’s dire fiscal situation. (In fact, the word “debt” was not even mentioned during the candidates’ one-and-only presidential debate.) The Trump-Pence administration did not take any meaningful action to reduce the structural deficit. Neither did the Biden-Harris administration.

The national debt, if left unaddressed, could trigger a fiscal crisis in which eroding investor confidence leads to a large spike in interest rates. It could also lead investors’ expectations of future inflation to drift above the Fed’s target, which would also lead to higher interest rates.

But all is not well in the absence of a crisis. High debt and deficits have been subtly damaging the economy for decades, and will continue to do so until they are addressed. Each additional dollar of deficit spending lowers private investment spending. Less investment leads to a smaller stock of capital, which in turn causes slower productivity growth. Workers who are less productive earn lower wages and incomes. And lower wages leads to fewer adults participating in the workforce.

Beyond slower productivity growth, lower wages, and less workforce participation, large federal outlays for debt service reduces the political space for needed investments in national defense, scientific research, and opportunity policies.

The national debt threatens democratic capitalism not only by weakening the economy and hurting the economic prospects of current and — importantly — future workers. In addition, it is a symptom of the political system demonstrating inadequate concern for the economy. The structural budget deficit is not a pawn in a political chess match between the two political parties. Instead, the lack of concern both parties have shown for fiscal consolidation is a sign that the political system is not responsive enough to real economic challenges.  

Conclusion

The fall of 2024 finds the United States on track to overcome the surge in consumer price inflation that began in 2021. That surge can be understood in large part as an imbalance in our system of democratic capitalism. But two other major threats to democratic capitalism remain: the growing bipartisan support for industrial policy and the growing bipartisan indifference towards addressing the national debt.

Even given these threats, democratic capitalism remains healthy in the United States. The economy continues to provide the employment opportunities, wage growth, and prosperity that support the legitimacy and longevity of liberal democracy. And, in the main, the U.S. political system largely respects the boundaries it must place on itself to maintain a market economy free enough to drive prosperity forward.

Over the long run, democracy cannot survive without free markets and capitalism cannot persist without democratic politics. This marriage matters. At the time of this writing, the outcome of the 2024 presidential election is unknown. It would benefit the winner of that contest to remember that damage to one half of this marriage damages the whole.