The title character of Horatio Alger’s 1867 novel Ragged Dick is an illiterate New York bootblack who, bolstered by his optimism, honesty, industriousness, and desire to “grow up ’spectable,” raises himself into the middle class. Alger’s novels are frequently misunderstood as mere rags-to-riches tales. In fact, they recount their protagonists’ journeys from rags to respectability, celebrating American capitalism and suggesting that the American dream is within everyone’s reach. The novels were idealized, of course; even in America, virtue alone never guaranteed success, and American capitalism during Alger’s time was far from perfect. Nevertheless, the stories were close enough to the truth that they became bestsellers, while America became known as a land of opportunity—a place whose capitalist system benefited the hardworking and the virtuous. In a word, it was a meritocracy.

To this day, Americans are unusually supportive of meritocracy, and their support goes a long way toward explaining their embrace of American-style capitalism. According to one recent study, just 40 percent of Americans attribute higher incomes primarily to luck rather than hard work—compared with 54 percent of Germans, 66 percent of Danes, and 75 percent of Brazilians. But perception cannot survive for long when it is distant from reality, and recent trends seem to indicate that America is drifting away from its meritocratic ideals. If the drifting continues, the result could be a breakdown of popular support for free markets and the demise of America’s unique version of capitalism.

The fundamental role of an economic system, even an extremely primitive one, is to assign responsibility and reward. In animal packs, the responsibility of leadership and the reward of mating opportunities are generally assigned to the strongest. In human societies, responsibility tends to take the form of employment, and the rewards are money and prestige. Because physical strength has long since lost its importance, economic systems determine in various ways who receives the responsibilities and the rewards. The dominant criterion in traditional society was birth: the king’s firstborn son was the next king; the landowner’s firstborn son, the new landowner; and the son of the company’s owner, the next chief executive. Most modern societies, by contrast, try to select and reward according to merit. Indeed, surveys show that in the abstract, most people in developed countries agree with the idea that merit should be rewarded.

It isn’t easy to decide what constitutes merit, of course. Consider an environment with which I’m familiar: American academia. Let’s say you want to determine who the best professors are. How do you rank publications? Do you value the number of papers that someone has written, or their impact? How do you measure that impact—is it merely the number of times that a paper has been cited, or should citations be weighted by the importance of the journal that makes the citation? Do you value good citations (“This is a seminal paper”) and bad citations (“This paper is fundamentally flawed”) equally? What about teaching? How do you evaluate that? Should it be measured by students’ satisfaction, or should other criteria come into the picture? If so, which? And what about other dimensions, such as collegiality and “service” to the school? Any system of determining merit must assign various weights to each of these dimensions, a process that is inevitably somewhat arbitrary, and the arbitrariness can create the presumption of unfairness and favoritism.

As that example suggests, a system of measuring merit should be efficient and difficult to manipulate, and above all, it should be deemed fair—or at least not too unfair—by most of the people subject to it. We can now begin to understand why support for meritocracy translates so neatly into support for the market system. Markets are far harder to manipulate than, say, a list of tenure requirements that an academic committee has created, or—to take a broader example—the decisions of statist regimes determining which lucky citizens get which consumer products. The market system has the reputation, too, of producing efficient results. And it doesn’t violate the prevailing notion of fairness too much.

Naturally, not everyone embraces the market system. Probably the reason that intellectuals tend to reject it is that it doesn’t reward what they think is meritorious: Lady Gaga makes a lot more money than Nobel laureates do. But in America, people largely accept the system—not merely because they think that it will deliver a reasonably efficient outcome, but also because they consider it mostly fair. As in Horatio Alger’s stories, they believe, such virtues as honesty, frugality, and hard work will be rewarded.

But this rosy picture obscures a hard fact: meritocracy is a difficult principle to sustain in a democracy. Any system that allocates rewards on the basis of merit inevitably gives higher compensation to the few, leaving the majority potentially envious. In a democracy, the majority generally rules. Why should that majority agree to grant a minority disproportionate power and rewards?

To understand the difficulty, consider the University of Chicago, an institution that still attracts market-oriented people, thanks to its association with the great free-market economist Milton Friedman. Who could be more merit-minded than MBA students who attend such a place, investing tens of thousands of dollars and two years of their lives to reap the rewards of a meritocratic system? Nevertheless, in a move that contradicted the meritocratic spirit, Chicago MBA students voted in 2000 not to reveal their grades to recruiters. The reason was clear: allowing recruiters to distinguish among them based on merit would benefit a minority of them at the expense of a majority. Even the most meritocratic people, then, can vote against meritocracy when it damages their own prospects. No wonder meritocracy is so politically fragile.

However, two factors help sustain a meritocratic system in the face of this challenge: a culture that considers it legitimate to reward effort with higher compensation; and benefits large enough, and spread widely enough through the system, to counter popular discontent with inequality. The cultural factor is easy to spot in America, which encouraged meritocracy from its inception. In the eighteenth century, the social order throughout the world was based on birthrights: nobles ruled Europe and Japan, the caste system prevailed in India, and even in England, where merchants were gaining economic and political strength, the aristocracy wielded most of the political power. The American Revolution was a revolt against aristocracy and the immobility of European society, but unlike the French Revolution, which emphasized the principle of equality, it championed the freedom to pursue happiness. In other words, America was founded on equality of opportunities, not of outcomes. The subsequent economic success of the new country cemented in the collective perception the benefits of assigning rewards and responsibilities according to merit.

This historical heritage is reflected in American attitudes today. Income inequality in the United States is among the largest in the developed world. Yet in a recent survey of 27 developed countries by the Pew Charitable Trusts, only one-third of Americans agreed that it was the government’s responsibility to reduce income inequality; the country with the next smallest fraction to agree was Canada, with 44 percent, and the responses rose as high as Portugal’s 89 percent. Americans do not want to redistribute income, but they do want the government to provide a level playing field: over 70 percent of Americans said that the role of government was “to ensure everyone has a fair chance of improving their economic standing.”

This belief in equality of opportunity is supported by another belief: that the system is actually fair. Sixty-nine percent of Americans in the same survey agreed with the statement “People are rewarded for intelligence and skill,” a far larger percentage than in any other country. At the same time, only 19 percent of Americans thought that coming from a wealthy family was important for getting ahead, versus 39 percent in Chile, 53 percent in Spain, and a median response across all nations of 28 percent.

In America, the legitimacy of rewarding hard work is so pervasive that even undergraduates in the country’s leftmost precinct, Berkeley, apparently endorse it. Economists have created an experiment called the “dictator game,” in which a subject is given a sum of money and asked to divide it however he likes between himself and an anonymous player. The experiment has been run thousands of times, and on average, people give 20 percent of their money to the anonymous players, presumably out of altruism or compassion. Recently, however, economist Pamela Jakiela changed the conditions of the experiment. In one treatment, the subjects—Berkeley undergrads—were told that the anonymous players had worked hard; in another treatment, they were told that they had done nothing. The students, it turned out, were much more willing to reward the hard workers than the slackers. In still another experiment, in which the person allocating the money had to work hard to gain it (by sorting beans, as it happened), she was much less willing to give it away.

Don’t suppose that the culture of meritocracy is universal. When the same experiment was conducted in Kenya, it yielded opposite results, with the subjects more willing to reward luck than hard work. But in America, from Berkeley to Boston, people believe in greater reward for greater effort, and that belief helps protect meritocratic capitalism from the forces that threaten to undermine it.

A meritocracy can’t survive on a supportive culture alone, however; it must also confer benefits large enough for people to recognize them. It’s no accident that meritocratic systems emerge when their potential benefits are the most sharply felt. At the national level, that tends to occur in wartime, especially when the survival of a country is at stake. In 1793, when the French Revolution was threatened by the invading armies of other European powers, the Jacobin government started to promote talented soldiers, rather than well-bred ones. This simple innovation allowed the Revolution to beat back Europe’s better-armed and better-trained forces. A similar effect was demonstrated by a friend of mine who felt sick one day. His wife offered to call their doctor friend. “No, I’m really sick,” he said. “I need a real doctor.” When life is in danger, there’s an enormous benefit to choosing according to merit, not loyalty.

So a meritocratic system, to engender a broad consensus, must confer relatively sizable benefits, even if they aren’t necessarily so enormous as saving a country from defeat. That isn’t an easy task. In politics, for example—a field in which value is mostly redistributed rather than created—the benefits conferred by meritocracy are relatively small compared with the benefits conferred by cronyism. If I appoint my friends to office, even when they aren’t terribly competent, I lose relatively little efficiency and gain quite a lot of power. Hence meritocracy is difficult to sustain in government.

The same is true when a firm enjoys a monopoly. Since the firm’s market position isn’t at risk, it doesn’t benefit much from hiring the best people. Instead, its executives focus on bureaucratic infighting, trying to grab an ever-larger share of the profits from one another, and once again, hiring loyal workers pays more than hiring competent ones. Contrast that with what happens in a competitive market, in which firms find themselves constantly threatened by competitors. It doesn’t pay to struggle for a larger slice of the pie if the pie is at risk of disappearing: a larger share of zero is always zero. Better to fight to preserve the pie, even at the cost of getting a smaller piece. This is another way in which meritocracy is intrinsically related to free markets. Without the threat that arises from economic competition, organizations have no reason to be efficient and thus no reason to be meritocratic.

Meritocracy can give rise to virtuous circles. The more citizens see that the principle of rewarding merit is consistently and fairly applied, the more willing they will be to accept it. Their very acceptance means that the system will be applied more and more consistently and fairly, which in turn further increases support for it. But when a system is corrupt, it induces people to try to cheat. This makes the system even more unfair—a vicious circle.

These circles point to the existence of what economists call “multiple equilibria”—stable situations that are very hard to change. That is, a country that happens to have developed a tradition of decent meritocracy will generally be able to sustain it, even under adverse conditions, but in a country where the meritocratic tradition has never developed, introducing it will be incredibly hard. In an equilibrium, small perturbations tend to have no effect. If the perturbation is sufficiently large, however, an economy can find itself in a different equilibrium—from which it will once again find it difficult to move away.

The good news for the United States is that, unlike many countries, it occupies a meritocratic equilibrium. But America cannot rest on its laurels. When the fairness of the rules grows questionable and when the benefits of the system are distributed too unequally, the consensus for free-market meritocracy can collapse. Returning to a meritocratic consensus is next to impossible once you reach that point. And America is approaching it.

Two powerful forces are threatening to drive America from a meritocratic equilibrium to a nonmeritocratic one. Recall that to survive in a democratic country, a meritocracy must enjoy a welcoming culture and offer large, widespread benefits to citizens. In the United States, both of these factors are being challenged: the first by a spreading belief that markets are a bad method of rewarding the meritorious; the second by a reduction of the benefits that most people derive from those markets.

The housing bubble and the 2008 financial crisis played a major role in the moral delegitimization of markets. When new developments in Florida and Arizona, built under the pressure of astronomically high real-estate prices, sit empty, people start questioning the efficiency of market prices. When the difference between a comfortable retirement and an indigent one is determined not by hard work or by a frugal lifestyle but by lucky timing in buying or selling your house, people start questioning the fairness of the market system. The fact that the real-estate bubble was the second large bubble to pop in less than a decade further undermined trust in markets as a good indicator of where to invest resources.

But nothing upsets people like the perception that the rules don’t apply equally to everybody. When my children were small, they sometimes tried to play Monopoly. These attempts inevitably degenerated into arguments. My daughter, who is two years younger than my son, would claim that my son was cheating. My son, with the official instructions in hand, would protest his innocence. And he was right: he never invented any rule. Nevertheless, my daughter was right, too: my son was engaging in selective recollection of the rules, counting on my daughter’s ignorance and bringing up only the rules that were in his favor. Despite her youth, my daughter understood that something wasn’t fair, so she employed the only response she had available: giving up.

Her frustration was similar to what many people felt after the 2008 bailouts of the financial system. The system was certainly at risk, and some government intervention was just as certainly necessary. Yet it was false to say, as Federal Reserve chairman Ben Bernanke and Treasury secretary Henry Paulson did repeatedly, that the choice was between the Troubled Asset Relief Program (TARP) as it was proposed and the financial abyss: there were feasible—and, in fact, superior—alternatives. It didn’t escape most Americans that TARP was the largest welfare program for corporations and their investors ever created in human history. That some of the crumbs went to autoworkers’ unions didn’t improve things; in fact, it made them worse, showing that the redistribution was not an accident but a premeditated pillage of defenseless taxpayers by powerful lobbies. TARP wasn’t just the triumph of Wall Street over Main Street; it was the triumph of K Street over the rest of America.

The way the bailout was conducted damaged Americans’ faith in their financial system, in their government, and in the market economy. A BBB/Gallup poll conducted in April 2008, a few months before TARP was passed, indicated that 42 percent of Americans trusted financial institutions and that 53 percent trusted U.S. companies. In a similar survey performed in December 2008 by the Chicago Booth/Kellogg School Financial Trust Index, which I direct, these figures dropped to 34 percent and 12 percent, respectively. Moreover, 80 percent of respondents felt less confident about investing in financial markets because of the bailout. Their altered feelings weren’t the consequence of any ideological bias against government involvement; on the contrary, a majority of respondents believed that the government should regulate financial markets. They objected, rather, to the specifics of what the government was doing. One reason they objected was their perception that lobbying interests had influenced the intervention: 50 percent of respondents, for instance, thought that Paulson had acted in the interest of Goldman Sachs, not the United States.

But a stronger reason, presumably, was that the bailout made the system suddenly look fundamentally unfair. Why should outsourced workers, whose only fault was to have entered the wrong sector, bear the burden of market discipline, while rich bankers were offered a government safety net? In the December 2008 survey, 60 percent of Americans declared themselves “angry” or “very angry” about the economic situation. Their anger affected political decision making. In September 2008, when Congress voted against the first version of the Paulson plan, it did so in response to the anger pervading the country; in March 2009, Congress approved a 90 percent tax on AIG bonuses for the same reason; and when President Obama contradicted his advisors and condemned the bonuses paid to Merrill Lynch executives, he, too, was responding to widespread anger.

These episodes might have been brushed aside as bumps on an otherwise smooth ride if the benefits that Americans received from their market system—above all, Algeresque economic mobility—hadn’t been diminishing at the same time. For a long time, people believed that, despite the obstacles that they faced, either they or their children would better their positions one day. Indeed, according to a recent survey conducted by the Pew Economic Mobility Project, 72 percent of Americans today think that their economic circumstances will be better in the next ten years, and 62 percent think that their children will have a better standard of living than they themselves have.

Unfortunately, empirical evidence suggests that this mobility is becoming less common. Start with “intragenerational mobility,” the likelihood that a person will move from one segment of the income distribution to another. Typically, about 30 percent of the people in each income quintile move up to the next quintile over ten years. But intragenerational mobility seems to be decreasing, most notably at the bottom of the income distribution. The Economic Policy Institute finds that during the 1990s, 36 percent of those who started in the second-poorest 20 percent of the income distribution were still there a decade later, compared with 32 percent during the 1980s and 28 percent during the 1970s. Today’s Ragged Dicks are more likely to remain stuck shining shoes.

Another kind of mobility, “intergenerational,” refers to the extent to which people move up or down the economic ladder with respect to their parents. If children of low-income families tend to have low income themselves, for example, intergenerational mobility is low. A recent and shocking study by the Organisation for Economic Co-operation and Development showed that America was markedly less mobile in this way than other OECD countries. Furthermore, a study from the Federal Reserve Bank of Chicago reports that intergenerational mobility, while increasing between the 1950s and the 1980s, started dropping in the 1990s and dropped even more in the following decade.

Other statistics paint just as troubling a picture for the Ragged Dicks. Between 1989 and 2009, the real per-capita income of the poorest 20 percent of the population, as determined by the census, declined by 1 percent. The median national income increased by only 3 percent over the same period. It seems very much as though the benefits conferred by meritocratic capitalism are neither as great nor as widespread as they once were, and this change seems likely to weaken political support for the market system.

In fact, we can already see signs of this weakening in Americans’ dwindling support for a pillar of capitalism: free trade. In 2001, according to a regular survey conducted by the Pew Research Center, 49 percent of Americans were in favor of the North American Free Trade Agreement, which liberalized trade among Canada, Mexico, and the United States, while only 29 percent were against it. By 2010, only 35 percent were in favor, while 44 percent were against. The numbers were even worse among conservative voters, who might be expected to support free trade: only 28 percent of Republicans, and 24 percent of Tea Party supporters, thought that NAFTA was a good idea.

The time to act is now, before the United States follows either the socialist path of Europe or the Perónist one of Argentina, and what is necessary is nothing less than a rethinking of traditional political categories. America’s political spectrum has long been divided between a pro-business side, which understands economic incentives and wants to grow by playing on those incentives, and an antibusiness one, which—to quote Churchill—sees business as either a “predatory target to be shot” or a “cow to be milked.” This dichotomy is a leftover of the Cold War, when the entire world was divided between two ideological camps, one of them embracing private enterprise and the other opposed to it. Free marketeers, naturally, found the former a more welcoming home.

But it isn’t necessary to support big business to support free markets. Indeed, the two positions are often at odds, which is why so many Americans who love competition and freedom of choice nevertheless distrust the power that big business is gaining in our society. What we need is something that we might call a pro-market, not pro-business, agenda, one that defends the market system that has served America so well without supporting the businesses, whether they’re banks or car companies, that have grown, as the phrase has it, “too big to fail.”

Unfortunately, the pro-market, not pro-business, agenda fails to find much representation. Businesses—in particular, large businesses—often use their political muscle to restrict new entries into their industry, strengthening their positions but putting customers at a disadvantage. A pro-market policy, by contrast, favors competition, new entries to markets, equal starting points, and firms competing with one another on an even footing. But who will back such a policy? Not the traditional pro-business forces, obviously, and not the antibusiness ones either, which have little interest in free markets.

A pro-market, not pro-business, movement could redefine the political landscape, however. Consider, for instance, the problem of growing income inequality. Currently, the two approaches are either to deny the problem or to try to diminish it through taxation and redistribution—redistribution that reduces the incentives to create wealth to begin with. It’s as though you were to play a round of golf and then, at the end of the game, add strokes to the most successful players. What golf actually does, of course, is equalize the starting points of the players by imposing handicaps. That’s an approach that, if we imitated it in our economy, could make markets more inclusive and reduce income inequality.

A primary target for such handicapping would be the school system. Ragged Dick could rise to respectability by learning the three Rs with the help of a roommate; today, the education required to enter the middle class isn’t so easily obtained. In the math tests conducted by the OECD’s Programme for International Student Assessment, American kids score only 29th out of 41 developed nations, barely above Portugal. True, they do a bit better in reading (19th place). But it’s troubling that the United States is among the top 12 nations for the variability of scores, alongside countries like Brazil, Indonesia, Mexico, and Tunisia. High variability means that a share of the population performs significantly subpar. This group is denied its chance at the American dream before its members even start working. Clearly, we need a better school system, particularly for the poor, and the best way to create one is to provide lower-income kids access to better schools through a voucher program or other choice initiatives.

Another policy that could help would be a reform of the way corporations are taxed. Rather than helping new entrants, the current system taxes them heavily while offering sizable loopholes for large, politically connected incumbents. At 35 percent, the U.S. statutory corporate tax rate is one of the world’s highest. But this rate is often avoided by the largest firms. According to a Bloomberg Businessweek study, from 2005 to 2008, Boeing paid only 3.2 percent of its income in taxes, while Amazon paid 4.1 percent. Reducing the rate but enlarging the base is a quintessential pro-market, not pro-business, policy.

These are just two examples of what a meritocratic, pro-market perspective could bring to the political debate. Such a perspective is necessary to preserve broad support for the system that, with all its defects, has made America rich.

Top Photo: traveler1116/iStock