How can we make market-based capitalism a safer, more stable and sustainable system?
March 5, 2009
In one sense, this is nothing new. The history of capitalism is very much a continuum of tough tests. Financial panics, periodic recessions and even the Great Depression are all part of the stress testing that has long shaped the rough and tumble evolution of market-based capitalism.
But now the U.S. economy — the poster child of capitalism — is in the midst of its most wrenching financial crisis and recession since the 1930s. Many of the once-proud icons of corporate America stand at the brink of failure and collapse. The full force of U.S. government policy is being directed at arresting this potentially lethal implosion.
Emergency government investments in privately held companies — capital injections as well as backstop financing — have become an all-too-frequent outgrowth of what started out as a mere subprime crisis.
At the same time, compensation caps, home mortgage foreclosure mitigation efforts and politically engineered consumer lending programs all smack of a quasi-socialization of U.S. finance.
Add to that Washington’s newfound aggression on trade policy — “buy America” government procurement policies, along with Chinese currency bashing — and it seems as if the U.S. strain of capitalism is being turned inside out.
To be sure, recent government interventions have been targeted at a subset of specific companies within these industries — rather than at the entire industry itself. For example, capital injections under the so-called TARP framework were initially directed at just nine financial institutions, whereas emergency bridge financing was extended to two of Detroit’s Big Three.
Clearly, there are important behavioral spillovers between companies that have been direct recipients of government funds and those that have not received such assistance but are wary that they could be next.
Combining the direct and indirect effects in these two industries provides an outside estimate of the U.S. government’s recent “intervention share” of around 6-10% in the private economy.
That means, of course, that more than 90% of the private sector in the United States is still operating largely as a free enterprise system. That is not exactly consistent with the widely popularized image of a “bail-out nation” that has been offered up to depict a U.S. economy in chaos and a market-based system on the brink of collapse.
I would be the first to concede that for a crisis of the severity of the one currently under way, it is certainly possible that the government’s recent interventionist actions could end up being only the first of many such efforts to come. Should recent actions beget more interventions in the future, the current angst over the crisis of capitalism would only grow.
While I expect that a good deal more consolidation lies ahead for the American consumer, the historical “stickiness” of U.S. consumption habits argues for a more gradual — albeit prolonged — normalization of consumer demand.
Moreover, to the extent the recently enacted $787 billion fiscal stimulus package limits the contraction in aggregate demand and puts a floor on the depth of this recession, there is reason to be encouraged that the retrenchment of the U.S. consumer will proceed at a less disruptive pace than was the case in late 2008.
Time will obviously tell, but if that prognosis turns out to be correct, a sharp increase in the scope of interventions and bailouts is less likely than otherwise might be the case.
At the same time, the Federal Reserve now speaks of an enduring regime of extraordinary monetary accommodation and liquidity injections into dysfunctional markets and beleaguered financial institutions. In short, it’s hard to have much confidence in the case for a prompt post-crisis normalization of U.S. fiscal and monetary policies.
As Japan’s experience shows with painful clarity, once a post-bubble economy needs to go on the life-support of extraordinary fiscal and monetary stimulus, it is extremely difficult to wean the chronically ill patient from this medicine.
Nearly 20 years after the bursting of the Japanese equity bubble, that nation’s public sector debt stands at 148% of GDP, while the zero-interest rate policy of the Bank of Japan celebrates its 10th anniversary.
The same can be said of halfway measures on the road to nationalization for insolvent industries. The longer the ultimate solution is avoided for zombie-like companies, the more elusive the post-bubble exit strategy and the more dependent a weakened business sector becomes on ongoing government intervention and support.
All in all, as long as a decisive and transparent exit strategy from the policies of crisis containment is lacking, there is good reason to suspect that the debate over the efficacy of market-based capitalism will continue.
In the end, the true test of capitalism will most likely come from its ideological roots — in particular, from the ability of the body politic to endure the often harsh verdict of free markets and their all-too-frequent penchant for creative destruction. In crisis and recession, the tolerance for such pain is invariably subjected to its sternest test — a trial under duress that often turns into a destructive blame game.
The search for scapegoats can become an obsession — in effect, a lightning rod for national angst. But scapegoating can play an even more destructive role — it can bias and eventually undermine the re-regulatory fix that invariably follows any crisis.
Wall Street has been singled out as the villain in this crisis. On one level, this is understandable. Financial service firms did make many serious and regretful mistakes — from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. But they were hardly alone.
The modern U.S. financial system has long been under the purview of an institutionalized network of checks and balances — controlled by regulators, a politically independent central bank and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment.
Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess.
The question is, Why?
In this boom, there was everything to gain from keeping the magic alive. And much to lose by drawing it all into question. In short, the American body politic — from Wall Street to Main Street to Washington — was consumed by the hopes and dreams of the boom and desperate for the good times to continue.
And so, by the way, was the rest of the world — especially export-led developing economies whose newfound prosperity was built on selling anything and everything to over-extended American consumers. Literally, no one wanted this party to end.
But now the party is over — and painfully so for a world in recession and for markets in chaos. The task ahead is to pick up the pieces, learn the lessons of this crisis, and take actions to ensure these types of problems never occur again. The post-crisis fix can succeed only if it is grounded in the premise of shared responsibility.
A targeted politicized fix is not a solution to a systemic problem. Fix the system that gave rise to the crisis — not just the banks that have defined ground zero of a wrenching credit crunch. The piecemeal prescription of the blame game virtually guarantees there will be a next time — an even bigger crisis that deals an even tougher blow to market-based capitalism.
The dangers of a politically driven post-crisis vendetta cannot be minimized. The current mess is deeply rooted in an ideological approach to economic governance — namely, America’s recent penchant for market libertarianism. Alan Greenspan, the high priest of this approach, framed most of the Federal Reserve’s critical policy choices in the context of this ideology.
The equity bubble of the late 1990s was justified by the breathtaking acclaim accorded to IT-enabled productivity. Property bubbles were presumed to be local, not national — especially in an era of rising homeownership at the lower (or subprime) end of the income distribution.
And the credit bubble, together with the risk bubble it spawned, was offered as testament to the genius of financial innovation and American creativity. Market libertarians simply looked the other way as the United States lurched recklessly from bubble to bubble.
This resulted in the Fed’s blatant abrogation of its regulatory responsibilities during the Greenspan years. Nowhere was that more apparent than in the central bank’s failure to make the distinction between financial engineering and financial innovation.
Far from playing the widely popularized role as the ultimate shock absorber, the “originate and distribute” hallmark of the derivatives explosion became a lethal transmission mechanism of cross-border and cross-product shocks.
Ideology blinded America’s central bank, as well as its political overseers, to the imperatives of discipline — and let an unregulated and increasingly unstable free-enterprise system veer unnecessarily out of control.
Over time, this crisis will be seen more as a failure of governance rather than as an inherent flaw in the free-market system itself. The post-crisis fix will, indeed, turn Wall Street inside out. But the new regime must also include a revamped code of governance—not just regulatory streamlining and reform but also the hardwiring of “financial stability” into the policy mandates of central banks.
Independent central banks that operate apolitically and free of ideology could well be the most important stewards of a post-crisis capitalism. But they can’t do it alone. Only through better discipline and more effective governance of regulators, rating agencies, and the political oversight function, can the invisible hand start to work its magic once again.
We can and must do much better in making market-based capitalism a safer, more stable and sustainable system. There has been a major systemic failure of the model that has held the world together since the 1930s. Governance, or the lack thereof — both within the private sector as well as by those charged with regulation and oversight — proved to be the weak link in the chain. Fix that, and capitalism will be just fine.
Should recent actions beget more interventions in the future, the current angst over the crisis of capitalism would only grow.
The current mess is deeply rooted in an ideological approach to economic governance — namely, America's recent penchant for market libertarianism.
It seems as if the U.S. strain of capitalism is being turned inside out.
The search for scapegoats can become an obsession — in effect, a lightning rod for national angst.
Wall Street has been singled out as the villain in this crisis. On one level, this is understandable.
Stephen S. Roach
Former Non-Executive Chairman of Morgan Stanley Asia Stephen S. Roach is a senior fellow at the Jackson Institute for Global Affairs, Yale University, and a member of the Yale School of Management faculty. He was previously the Non-Executive Chairman of Morgan Stanley Asia (a position he held after serving as managing director and chief economist […]