With the collapse of British socialism and Soviet (and satellite) communism, and the rapid economic growth of countries like China and India when they took significant steps toward a free-market economy, it seemed that capitalism had triumphed. But today, in the wake of the financial collapse of 2008 and the ensuing worldwide economic downturn, there are a growing number of doubters.
As Becker points out, and as I have pointed out in my writings on the economic crisis of the past three and a half years, a combination of unsound monetary policy and regulatory laxity (nourished by the complacency of many influential macroeconomists) triggered a sudden, broad, and deep weakening of the banking sector (defining “banking” broadly to include any financial intermediary, whether or not it is regulated by banking agencies), a sector that is fundamental and pervasive in modern economies. Banking is inherently risky, because the basic model of banking is borrowing short and lending long (to create a spread, because interest rates are higher the less liquid the loan; without a spread a bank has no income). By 2008 most bank capital, though indeed short-term (much of it, indeed, borrowed overnight), was not insured by government. So the collapse of the U.S. housing market, in which that capital was heavily invested, precipitated a series of runs, and the runs froze credit, which disrupted the nonfinancial economy, leading to a downward economic spiral (layoffs by financial and nonfinancial firms alike, resulting in lower spending by consumers, in turn resulting in more layoffs, and so on).
Banking is fundamental to capitalism, and financial instability is an inherent danger in banking, and a banking collapse can create widespread and persistent economic distress, and this combination helps to explain why the worldwide depression of the 1930s generated unprecedented support for socialism and communism. But socialism and communism have been discredited, and so there is no longer an alternative to a capitalist system—and thus no alternative to sensible monetary and regulatory policies that would avert a repetition of the 2008 and earlier financial crises.
I think there may be a looming crisis of capitalism, though one that has nothing to do with banking, but rather with technological progress, and specifically with the effect of that progress on income inequality. Technological progress in recent decades has included not only the well-known advances in computerization, communications, and medical treatment, but also important advances in marketing, including political influence and manipulation, and management. The overall effects of these advances on many fronts have included a sharpening of competition, an increase in government debt to finance middle-class entitlements, particularly medical, a reduction in the demand for manual labor, and an increase in the financial returns to IQ and to higher education (which are correlated). These developments seem to be increasing the inequality of income and wealth and creating sharper class divisions than the nation had become accustomed to in the decades following the end of the 1930s depression.
There is nothing in the economic logic of capitalism, any more than in the biological logic of evolution, that drives an economy toward income equality. The basic logic of both systems is competition, and competition produces losers as well as winners. A class of workers can become extinct, just as a species can. The difference is that the combined effect of envy and democratic politics can result in policies that distort competition in order to increase the welfare of the losers in the competitive struggle. Such policies tend to be inefficient and thus to retard the smooth operation of capitalism as an economic growth engine. Evidence for this proposition is found in the sluggish economic performance of many European nations.
Growth-impairing policies that might reduce economic inequality include restrictions on the immigration of wealthy persons and highly educated persons, the promotion of unionization, heavy business taxes, high marginal rates of personal income taxation, government subsidization of business activities (“picking winners”), high government debt, a generous safety net that reduces incentives to work, and heavier government financing of education for members of lower-middle-class families. Such policies—most of them involving turning back the clock to the 1950s—would probably reduce the rate of economic growth. Could the impact of that reduction on future welfare be offset by gains in social peace? At present, the answer seems to be “no,” but if signs of social unrest, such as the Tea Party and Occupy movements, grow, the answer may at some point need to be reconsidered.