Capitalism in Crisis is the title of a long series of articles in the Financial Times by many participants. No doubt, the severity of the Great Recession has temporarily weakened the respect for capitalism, for “free” markets, and among other things, for the Chicago school of economics. Yet I will argue that the FT’s title should have had a question mark, as in: Is capitalism in crisis? My answer is that while certain aspects of the economic organization of capitalist countries like the United States should be changed to reduce the chances of future severe recessions, it remains true that economies which are competitive and capitalistic have the best prospects for sizable long-run economic growth.
The Great Recession reinforced the lesson of prior panics and financial crises, lessons forgotten during the Great Moderation from about mid 1980s to 2006, that the financial sector has a fundamental built-in instability. In the past this was mainly associated with “runs” on banks, as during the Great Depression of the 1930’s. The instability of modern financial institutions is no longer much related to bank runs because of deposit insurance; rather it is mainly the result of the incentive for financial institutions to raise their profits by increasing their assets relative to their capital.
One straightforward way to reduce this instability is to raise capital requirements of banks and other financial institutions. Greater capital would provide banks with bigger cushions if the value of their assets fell as a result of a crisis in asset markets. Any mandated capital/asset ratio should be greater for banks that are considered too big to fail than for other banks in order to make it less likely that larger banks would need a bailout. The United States and Europe have already moved to increase capital requirements for banks. These rules will have to be adapted over time as banks discover ways to mitigate the impact on their lending.
Asset price bubbles are another issue to deal with. The collapse of the “bubble” in Internet companies in the US during the late 1990s did not have a major impact on the US economy because it affected only a small part of total assets. Similarly, the many bubbles in local housing markets in the past, such as the Florida land boom of the 1920s, greatly affected these local markets, but did not have much affect on the US economy because they were not important to the overall economy. However, unlike these previous local housing booms, the boom from 2002-07 was national, although clearly stronger in certain regions, like Las Vegas, than in other regions. The collapse of this boom had a big enough impact on consumer and bank assets that it did seriously affect the US economy.
The boom in housing prices was related to the low interest rates after the early 1990s, and also to the growing number of mortgages that required neither much of a down payment nor decent credit histories. To reduce the likelihood of such housing bubbles in the future, it might be wise to require larger down payments to get mortgages, so that mortgage owners would have more “skin in the game”. Of course, politicians would likely oppose higher down payments because younger and other households with limited capital would find it harder to buy homes.
While vast attention has been given to the failures of capitalism after the financial crisis erupted, government “failures” that contributed to and prolonged the crisis have received much less attention. Yet government failures were numerous and important. These failures include the Fed’s decision to keep interest rates low after 2003 even though asset markets were booming, and the many bank regulators and other government officials who cheered on the expansion of bank assets rather than trying to control assets/capital ratios of banks. Government failures also include the congressmen and other government officials who encouraged, and even required, banks to offer mortgages to households with bad credit histories, and to households who could provide only a small amount of equity in their homes. Not the least of government failures are the many state and local governments, and countries like Greece, Ireland, and Portugal, that took advantage of the good times preceding the crisis to increase greatly government spending and debt beyond reasonable levels.
It is because of government regulatory failures that I believe the best hope for preventing banks and households from excessively expanding their debt in the future lies in rules, like capital requirements, rather than in greater discretionary power to regulators. Regulators misuse discretionary authority because they often get caught up in the same euphoria that banks and households succumb to. In addition, they sometimes get “captured” by the banks and households they are regulating, and end up being cheerleaders for these sectors.
Yet the fact that financial and housing markets did “fail” in the years leading up to the financial crisis (although their failure was partly induced by bad government policies and poor regulatory oversight) does not add up to a crisis in capitalism as a whole. The vast majority of competitive markets in a capitalist economy like that of the United States performed quite well both before and during the crisis.
China’s form of state capitalism is often considered to be a good alternative to competitive capitalism. China has had an astounding economic record during the past 30 years, but the private sector has been the most productive and dynamic part of its economy. China’s growth started when in the late 1970s it opened farming to the private sector. China has steadily increased the share of output produced by the private sector. Public enterprises are still important, but China has grown despite the important of state-owned enterprises, not because of it.
Capitalism lost prestige as a result of the severity of the Great Recession, but so too did governments. I do not believe that capitalism is in a real crisis, partly because the defects in financial and housing markets can be corrected to a significant extent. More importantly, reliance on competitive capitalism has been the only way that countries have been able to reduce poverty and continue to grow over long periods of time. The great majority of developing and other countries will not forget this fundamental reality as the world pulls out of the Great Recession.