Advancing a Free Society

Is Capitalism in Crisis?

Monday, February 13, 2012

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.

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