Don’t Let the Cure Destroy Capitalism

Wednesday, July 1, 2009

Capitalism has been wounded by the global recession. But even as governments continue to ponder how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

Consider the following extraordinary statistics about the performance of the world economy since 1980. World real gross domestic product grew by about 145 percent from 1980 to 2007, or roughly 3.4 percent a year. The so-called capitalist greed that motivated businesspeople and ambitious workers helped hundreds of millions climb out of grinding poverty. The role of capitalism in creating wealth is seen in the sharp rise in Chinese and Indian incomes after they introduced market-based reforms (China in the late 1970s and India in 1991). Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism (and it deserves a good share of the blame), the recession-induced losses pale in comparison with the great accomplishments of earlier decades. Suppose, for example, that the recession turns into a depression in which world GDP falls in 2008–10 by 10 percent, a pessimistic assumption. Then the net growth in world GDP from 1980 to 2010 would amount to 120 percent, or about 2.7 percent a year over this thirty-year period. This allowed real per capita incomes to rise by almost 40 percent even though world population grew by roughly 1.6 percent a year during the same period.

Therefore, in devising reforms that aim to reduce the likelihood of future severe contractions, we need to appreciate the accomplishments of capitalism. Governments should not hamper markets so that they are prevented from bringing rapid growth to the poor economies of Africa, Asia, and elsewhere that have had limited participation in the global economy. New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. This runs counter to a common but mistaken view, even among many free market proponents, that it is better to do something to try to help the economy than to do nothing. Most interventions, including random policies, by their very nature would hurt rather than help, in large part by adding to the uncertainty and risk that are already prominent during this contraction.

Government reactions have demonstrated that interventions designed to help can exacerbate the problem. Even though we had well-qualified policy makers, we have gone from error to error since August 2007.

The policies of the Bush and Obama administrations violate the “do no harm” principle. Interventions by the U.S. Treasury in financial markets have added to the uncertainty and slowed market responses that would help stabilize and recapitalize the system. The government has overridden contracts and rewarded many of those whose poor decisions helped create the mess. It proposes to override even more contracts. As a result of the Treasury’s actions, we face further distorted decision making as government ownership of big financial institutions threatens to substitute political agendas for business judgments in running these companies. Although such dramatic measures may be expedient, they are likely to have serious adverse consequences.

These problems are symptomatic of three basic flaws in the current approach to the crisis. They are an overly broad diagnosis of the problem, a misconception that market failures are readily overcome by government solutions, and a failure to focus on the long-run costs of current actions.

Even if the recession is entirely blamed on capitalism—and it deserves a good share of the blame—the losses pale in comparison with the great accomplishments of prior decades.

The rush to “solve” the crisis has opened the door to government actions on many fronts, most of which have little or nothing to do with the crisis or its causes. For example, the Obama administration has proposed sweeping changes to labor market policies to foster unionization and a more centralized setting of wages, even though the relative freedom of U.S. labor markets in no way contributed to the crisis and in fact would help shorten it. Similarly, the backlash against capitalism and greed has been used to justify more antitrust scrutiny, greater regulation of a range of markets, and an expansion of price controls for health care and pharmaceuticals. The crisis has led to a bailout of the American car industry and a government role in how it will be run. Even one of the most discredited ideas, protectionism, has gained support under the guise of stimulating the economy. Such policies are a mistake. They make no more sense today than they did a few years ago and could take a long time to reverse.

We see clear market failures in the collapse of financial innovations such as securities backed by subprime mortgages, the problems caused by risk models that ignored the potential for steep falls in house prices, and the overload of systemic risk. At the same time, innovations in finance also contributed to the global boom during the past three decades.

The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments saw large declines in their wealth, and the investors that funded those institutions without proper scrutiny have seen their wealth cut in half or more. Households that overextended themselves have also been badly hurt.

Given the losses, actors in those markets have strong incentives to correct their mistakes next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private-sector adjustments. Greater private recapitalization is hindered by uncertainty: muddled Treasury policy on bank capital and ownership structure, the willingness of the government to change mortgage and debt contracts unilaterally, and the unclear nature of future regulation and subsidies. Rather than solving problems, such policies tend to prolong them.

The federal stimulus package falls into the same category. It is partly based on the belief that government spending is required to stimulate the economy because private spending would be insufficient. The focus on government solutions is particularly disappointing given its poor record in dealing with crises in the United States and many other countries, including Hurricane Katrina and the war in Iraq.

Most interventions, including random policies, hurt rather than help. They add to uncertainty and risk.

The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better and in many ways worse. Regulators became caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them. Output, employment, and earnings all have been damaged by the crisis.

Nevertheless, even big downturns represent only pauses in long-run progress if we keep the engines of long-term growth in place. That growth depends on investment in human and physical capital and the production of new knowledge, all of which require a stable economic environment. Uncertainty about the scope of regulation is likely to have the unintended consequence of making those investments more risky.

The Great Depression induced a massive worldwide retreat from capitalism and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India, and Africa.

Even one of the most discredited ideas, protectionism, has gained support under the guise of stimulating the economy.

Partly owing to the collapse of the housing and stock markets, hostility to businesspeople and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the only one that can deliver further large increases in wealth and health to poor as well as rich nations. We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for thirty years.