Monday, October 20, 2008
In the sense of being 'mixed economies', capitalism has performed spectacularly well through history. It has raised many societies from desperate poverty to prosperity. Moreover, it has performed spectacularly well in increasing incomes around the world and in reducing poverty over the past few decades. For example, numbers living in extreme poverty around the world - those earning less than $1US per day - fell by between 1/2 to 1/3 of their 1970 levels by 2000. Developed countries have experienced what can only be described as an extended period of sustained economic expansion with Australia, for example, enjoying what is perhaps the longest period of sustained economic expansion in its history - a continuous, strong economic expansion for 17 years. Living standards have improved markedly, inflation has remained low and unemployment rates fell in 2007 to their lowest level in 34 years.
The tremendous success of capitalism is part of the source of its recent dramatic problems. With continuous prosperity those aspiring to accumulate wealth have responded to the current prosperity with what Adam Smith would have called an 'overwhelming conceit' - modern economists describe this as an enhanced 'optimism bias'. Citizens have leveraged up by borrowing incautiously to purchase housing and financial assets in the expectation that their values would steadily increase in line with the continuing prosperity. Caution and fear have been forgotten by many. Those with longer memories have sounded warnings about this new found 'irrational exuberance' but these warnings have typically been ignored.
The current financial crisis has ended the exuberance and raised perennial questions about the 'staying power' and adaptability of capitalism. The crisis has led to speculations about the extent to which there will be increased future government control of the economy and the type of regulatory reforms that are likely to occur. For a few (incredibly naive) individuals it has raised question about whether capitalism should be replaced by a socialist system where party bureaucrats direct what investments should be undertaken and what society should consume. For all sensible people the question is what are the lessons for regulating capitalism more effectively?
This Slate article (HT to Cato at Catallaxy) eloquently summarises my view on the implications of the financial crisis for the evolution of our economic management ideas. The crisis in my view offers little support to the enemies of capitalism but it does confirm that extreme libertarianism or 'free market fundamentalism' (FMF) has a limited role in thinking about how financial markets, at least, should operate. Market regulation has failed in certain areas but capitalism as a whole has not.
Putting the issue in these terms suggests that the changes we will observe as a consequence of the current crisis will mainly take the form of rethinking the way we regulate capitalism rather than having thoughts about an overall failure. Indeed, when the issue is posed thus, really nothing very new is actually being suggested. Almost none of my economics colleagues - or the economic researchers I know of internationally - would subscribe to FMF, at least in the sense that Slate understands it. Most practical economists regard libertarianism as an intellectual disability that exhibits itself in a way akin (although, in effect, opposite to) the ideological rants of doctrinaire socialists and naive revolutionary socialists with their crazed insistence that markets can never work so that governments must run everything. For most economists the 'mixed economy' comprising mainly markets but with significant government involvement and with social democratic values imposed to 'civilise capitalism' (but with a general preference for liberalising trade and a dislike of 'nanny state' paternalism) is the reality and provides the core reference economic/political model.
Most economists I know learnt their economics from a text such as Paul Samuelson's famous Economics. This text - and a generation of imitators which followed it - acknowledged the supreme value of markets in efficiently distributing resources but emphasised that markets often do not work well so they therefore need regulation. We know market failures arise with external environmental costs and with public goods (Adam Smith recognised this) that are best provided by regulated natural monopolies. We know generally that monopoly power itself should be controlled. Moreover Samuelson was a reader and interpreter of Keynesian economics so he saw the imperative for active macroeconomic management. As Samuelson's students, most of us take for granted the standard Keynesian view that the economy cannot be relied on to gravitate towards equilibria where all markets clear and resources are fully employed. While Keynes himself was focusing on economies which had high levels of unemployment the general point he made is that economies cannot reasonably be considered to be self regulating. Hence there is a need for regulation.
In the 1970s and the 1980s a small (though influential) group of economists and right-wing political figures began to blame the high levels of inflation and unemployment that then prevailed in developed economies on the theories of Keynes. The argument was that governments, by attempting to 'pump prime' economies when they experienced downturns, would inevitably create sustained inflation which would, in turn, become built into people's expectations thereby leading to the eventual need for restrictive monetary policies to demolish these damaging expectations. By doing this such policies would necessarily drive higher unemployment. High rates of inflation would come to be expected and taken for granted in setting lending rates and wages so that monetary expansions would not increase demand but simply raise inflationary expectations and simply defer the time that recession had inevitably to be experienced.
In my judgement this analysis is broadly correct but this is no argument for FMF. Instead it provides a case for maintaining moderate rates of monetary expansion, for targeting low inflation rates and for using monetary policy sparingly. Moreover, it has literally nothing to do with arguments for deregulating financial markets although this is an association often observed.
Since Samuelson wrote the early version of his famous textbook, economists have become more concerned with the role of uncertainty in markets and with the prospects for people taking actions in the face of this uncertainty that can produce market failures. Often these failures involve principal and agent problems. Here participants in markets acting as agents for others take advantage of private information to engineer good outcomes for themselves at the expense of society. Contrary to Gordon Gekko's famous dictum, greed in this setting is not good - it damages society. Self-interest does not drive the social advantage.
Considering recent events and concentrating primarily on the US economy we can discern these conflict-of-interest issues as key causal factors in the current crisis:
1. There have been severe 'principal and agent' problems in US mortgage markets. Partly this was due to the actions of brokers who provided mortgage loans to house buyers and who received a commission for doing so based on loans sold not loans that were successfully repaid. These brokers had individual incentives to provide loans to non-credit worthy borrowers because this maximised their advantage but left society exposed to huge systematic risks and bad debts.
This outcome was fed in part by comprehensive attempts in the US to increase home ownership levels through an attack on underwriting standards that began in the early 1990s. Academics and regulators applauded the decline in these standards as an 'innovation' in mortgage financing that would help to increase levels of home ownership among the poor and particularly among minority groups. The resulting disastrously high levels of foreclosures were partly a reflection of bad values and partly an issue of misplaced social romanticism.
In fact, high levels of mortgage foreclosures in the US started to occur in 2006 well before there was a dramatic decline in US property prices when the US economy was quite strong. However the surge in foreclosures that has occurred in 2008 - and which has occurred in prime as well as subprime markets - has dramatically increased pressure on property prices and worsened the financial crisis.
It is important to note that the financial crisis that has developed is not one primarily of bankruptcy and bad debts. The mortgage and credit card losses experienced in the US could have been paid for amounts already contributed by the US Government in bailouts. The key problem in current markets is fear that loans may be awarded to those with solvency issues. The problem is exacerbated by the fact that those most actively seeking loans are those with solvency concerns - this is adverse selection. Hence there has emerged a resulting freeze on lending that cripples business and households. This fear is an intangible that can best be met by restoring confidence through short-term public guarantees and through governments taking equity in financial institutions to make clear their market viability.
2. Rating agencies (for example Moodys, Standard and Poors) who have derived fees for providing accurate signals concerning the credit worthiness of various securities are subject to conflicts of interest because the issuers of securities pay these agencies to have their securities rated. This gave rise to what can only be described as rorts. These agencies nominally only provide 'advice' that can be accepted or rejected but this advice in fact often has quasi-official status with many institutions (including Australian local governments) only being allowed to invest in certain instruments if they do have a AAA ranking. Relying on these private firms to provide financial information in a setting where rating agencies face incentives to deceive and where they are bound by ideological biases, amounts to an inappropriate privatisation of regulation.
3. US Lending institutions (such as Fannie Mae and Freddie Mac) who issued mortgages to sub-prime borrowers did so with a degree of abandon because they believed that the value of their loans was subject to an implicit government guarantee - this is an instance of what economists call 'moral hazard'. Here lenders will exercise reduced care over lending deposits because the value of deposits is guaranteed. Indeed, the earlier Savings and Loan Crisis of the 1980s and 1990s resulted from a liberalisation of the capacity of S and L institutions to lend to a broader class of risky borrowers while at the same time deposits were being guaranteed by the US Federal Government. Politicians and regulators should have learnt more from this earlier disaster. The S and L crisis eventually cost the US taxpayer $160 billion while the current crisis -which involves the same type of moral hazard - will cost the US government up to $1.25 trillion! The failure to learn has brought about increasing costs!
Providing such things as 'deposit guarantees' looks like a sensible regulatory device to the person in the street. It is not however if it encourages the managers of such deposits to gamble wildly on the understanding that governments will come to the rescue should things not work out. It then can become a 'heads I win, tails I don't lose much' proposition - a fact that knee-jerk populists like Kevin Rudd do not understand when they guarantee the deposits of a subset of Australian financial institutions but do not consider broader ramifications.
4. There are particular problems associated with the complexity of recent innovative financial products that have proliferated in global capital markets. Warren Buffett has described derivative contracts as instruments of 'financial mass destruction' which seems an accurate description. While these instruments can potentially be used to reduce risk - their stated rationale - their value depends on the credit-worthiness of the counterparties to them. Those issuing these securities - particularly when they are very complex - also have incentives and the ability to make fanciful assumptions about their likely profitability and to thereby inappropriately boost their own apparent financial standing. These problems cannot be swept under the carpet. They call for regulation. Indeed, there is nothing particularly new about this claim. Issuers of totally unregulated credit market derivatives have been known to pose a threat to the international monetary system since 1997 when the super-leveraged hedge fund Long-Term Capital Management failed.
The difficulty here was not that the problem was not recognised but that no-one acted to do anything about it. A few economists with extreme libertarian views - Alan Greenspan is a standout - got into positions of extraordinary political and economic power and maintained that these derivatives were simply an effective way of reducing risk without considering circumstances where they might become worthless thereby destabilising financial markets. Simply put they ignored the obvious and cloaked their viewpoint with an FMF ideology that ignored the implied risks.
There are further examples but these illustrate the main argument. In all cases there are market failures that result from particular people having asymmetrical information advantages in the face of uncertainty. People take advantage of such information asymmetries and failures to improve their own self-interest and to the detriment of society. The problem here is not the 'greed' of these agents, as moralising politicians suggest, since greed has been an important driver of human affairs since the start of history. The failure to foresee and to address these problems is a regulatory failure not an intrinsic defect of capitalism or of people's greed-driven values.
There were five other macroeconomic events that fostered the current dire situation:
(i) High rates of savings in China and among the oil exporters which - despite local investment booms - could not be absorbed entirely locally in the economies that gave rise to them and which therefore spilt over into international capital markets driving down global interest rates;
(ii) The long-term overvaluation of the US dollar (or equivalently the undervaluation of the Chinese currency) that facilitated the high rates of Chinese savings and which led to the debt-financed consumption-led boom in the US and other countries that was partly financed by resulting excessive balance of trade surpluses;
(iii) Inappropriate monetary policy responses in the US and elsewhere to the glut in global loanable funds markets that kept interest rates too low for far too long;
(iv) A boom that became a bubble in global asset and particularly housing markets as a consequence of the low borrowing costs and the exuberant expectations that reflected a sustained period of economic prosperity;
(v) As already mentioned, the commitment to increase levels of home ownership in the US that encouraged unprecedented levels of low quality subprime mortgages but which provided ammunition that the excessively deregulated financial sector ignited.
In addition, developments in the international economy have changed the economic environment in other ways we are only starting to understand. Globalisation has been seen as a boon by economists because it so effectively increased world trading opportunities. This is undoubtedly true but globalisation does have a downside in fostering financial complexity and possible contagion of financial shocks from one economy to another. The interdependence it engenders induces vulnerability of the global economy to shocks in particular economies. Moreover, with globalisation, financial institutions tend to become 'large' anyway so that shocks that do occur are also large.
Finally, the changing bases of economic power in the global economy have shifted our preceptions of how it works. In my view some of the stresses that are being observed currently signal the beginning of the end of US and European dominance in economic affairs and a shift in power toward emerging countries such as China, India as well as countries in Eastern Europe, the Middle East and South America. That the US has had its excessively high consumption standards facilitated by excessive savings in emerging countries like China suggests that the imperial empire (the US) is borrowing to sustain a continued role that is increasingly non-viable given the march of history. The world will be a better place when countries such as China do develop into major economic powers with their own substantial scientific and artistic identities and the US should welcome not fear this. But the implications of such developments are only starting to be appreciated and understood. They imply the need for the US to rethink its role as a dominant economic power.
What are the implications of the current crisis for the future of capitalism? There is no possibility that the countries will adopt socialist administrations of the type currently residual in North Korea and Cuba despite the incoherent ramblings of radicals. Presumably those arguing for a socialist society on the basis of current problems have in mind a theoretical model of socialist perfection that will replace a capitalist system with its obvious defects. But this is committing the same logical fallacy that critics on the right make when they compare current imperfect economic systems with idealised models of laissez-faire capitalism. Both viewpoints compare the real with the hypothetical and both lack realism.
More realistically we now face the definite prospect of a more regulated financial system. No-one can plausibly deny that their have been regulatory failures and shortcomings even if some of the failed regulations were initially well-motivated. Moreover, it must be acknowledged that the increased complexity of operating in a global environment where there are a significant number of large players can increase the returns to more coercive and intrusive regulation.
Is permanent nationalisation of the banking system a likely longer-term prospect? Clearly the significant stakes that European and US governments will or have taken in the banks do indicate a drift toward socialism (on any reasonable definition) and there will be the likelihood of greater regulation of the direction of lending and such things as executive compensation. It is difficult however to determine how long such interventions will be sustained. In the case of the US and the UK there is the likelihood of eventual substantial divestments of publicly-purchased equity for budgetary as well as efficiency-based reasons.
Government controlled banks may remove some capitalistic excesses but will impose problems of their own because of incentive issues endemic to public ownership. Politicians typically face short-term political constraints that are inconsistent with economic logic and which can be both headline driven and overly conservative. If politicians rule over capital markets a new type of systematic inefficiency will plausibly develop that reflects, at core, the reason that most economists reject socialism. Looking at the current Australian scene, for example, it seems to me that disastrously inept and wasteful government investments in 'green car' technologies and 'Food Bowl' projects offer no encouragement that government run banks would outperform private enterprise in minimising wasteful social investments.
It is true that - even apart from the current problems - there is a general rethink of the role of government in economies such as the US. US wages have stagnated over recent decades while the concentration of income going to the highest income earners has grown strongly. Even conservatives such as Alan Greenspan have criticised this trend. But the US is an outlier in its respect for FMF that has justified increasing income inequality via regressive tax cuts. This is a bias that will plausibly be soon removed by a very plausible and likely change in US political leadership.
The move by the US government to provide $25 billion handouts to the US automobile industry represents a very clear trend towards increased government involvement in the economy. These grants are conditional on meeting government objectives of more 'fuel efficient' cars. This is probably a poor move given the long-term pressures that work against mass manufacturing of automobiles in the US. More fundamentally it is wrong to foster an economy that rewards and saves poor performers.
The fear is that the current intervention with respect to the banks will be seen as a precedent for blind acceptance of increased government involvement in broader sections of the economy such as health, education, transport along with possible greater restrictions on free international trade and investment. Such restrictions would endanger living standards and would help to keep millions of people in developing countries poor by denying them access to foreign markets. It also denies residents in developed countries to inexpensive products. We need to learn from the current crisis and adapt our regulatory settings not 'shoot ourselves in the foot' with pointless restrictions that reduce our freedom and which cripple the economy by building inefficiencies into it.
Society will change as a consequence of the current crisis and hopefully the incentives for 'get-rich-quick' schemes through debt-funded investment in housing will be diminished. There may be some sort of return to old-fashioned values of 'living within means' and therefore not being excessively leveraged. There will also be less of the economic complacency that has been induced by the long-term boom that operated up to the current crisis. Currently an Australian aged 30 has lived all his or her teenage and adult life in an economy that has steadily expanded. That has now changed and it is natural to suppose that, as a consequence, we will become more fearful and cautious. This increased caution may have costs in terms of excessive risk aversion as well as obvious individual benefits.
Finally, I think the discipline of economics will change in response to current events just as it did so dramatically after the Great Depression and the period of high inflation in the 1970s/1980s. Specific changes will include a reassessment of the view that derivative contracts can reduce risk . More generally there will need to be a broader rethink of financial regulation policies. One issue of prominence will be international regulatory regulation. Part of the reason for the current financial problems is the competitive pressures not to regulate domestic monetary sectors intensively because of the prospects of operating in a less regulated international financial economy. The need for rethinking the regulation of international financial markets will be heightened by the expanded role that China will be expected to play in the global economy.
These are issues that deserve greater attention than I can give them now but which will increasingly play a part in unfolding debates.
Update: Gary Becker and Richard Posner elaborate these issues. One of their main points is to link likely changes in the structure of capitalism to the extent of the damage it causes.