The Wisdom to Start Again

Monday, August 13, 2012

“Capitalism in Crisis” is the title of a recent series in the Financial Times. No doubt the severity of the Great Recession has temporarily weakened the respect for capitalism, free markets, and, among other things, the Chicago School of economics. Yet I argue that the title should have ended with a question mark: “Is Capitalism in Crisis?” My answer is no. While certain aspects of the economic organization of capitalist countries like the United States should be changed to reduce the chances of severe recession, it is still true that competitive, capitalistic economies have the best prospects for sizable, long-run economic growth.

The Great Recession reinforced the lesson of prior panics and financial crises—a lesson forgotten during the “Great Moderation” from about the 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 1930s. The instability of modern financial institutions is no longer much related to bank runs, thanks to deposit insurance; rather, it is mainly the result of the incentive for financial institutions to raise profits by increasing assets relative to capital.

One straightforward remedy for this instability is to raise the capital requirements of banks and other financial institutions. Greater capital would give banks 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 considered “too big to fail” than for other banks; this would 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. Such rules will have to be adapted over time as banks discover ways to mitigate the impact on their lending.

It would be wise to require larger down payments so that mortgage owners have more skin in the game.

Asset price bubbles are another issue. The collapse of the bubble in Internet companies during the late 1990s did not have a major impact on the U.S. 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 effect on the national economy. However, unlike previous housing booms, the boom of 2002–7 was national, although clearly strongest in certain regions, such as Las Vegas. Its collapse hit consumer and bank assets hard enough to seriously affect the U.S. economy.

The boom in housing prices was related to low interest rates after the early 1990s and the growing number of mortgages that required neither a big down payment nor a decent credit history. In the future it might be wise to require larger down payments so that mortgage owners have more skin in the game. Of course, politicians would probably oppose this as a home-buying barrier to younger and limited-capital households.

Vast attention has been paid to the failures of capitalism amid the financial crisis, and far less to the government failures that contributed to and prolonged it. Yet government failures were numerous and important. They included the Fed’s decision to keep interest rates low after 2003 even though asset markets were booming. At the same time, many bank regulators and other government officials cheered on the expansion of bank assets rather than trying to control banks’ asset/capital ratios. Government failure also embraced the Congress members and other officials who encouraged, and even required, banks to offer mortgages to households who had bad credit histories or could provide only a small amount of equity. Not the least of government failures were the actions of many state and local governments—and worldwide, those of countries like Greece, Ireland, and Portugal—that took advantage of the good times to inflate government spending and debt beyond reasonable levels.

Government regulatory failures point to what I consider the best hope for preventing banks and households from excessive debt expansion. The solution lies in rules, such as capital requirements, rather than greater discretionary power for regulators. Regulators misuse discretionary authority; 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 cheerleaders for these sectors.

China has grown despite the importance of state-owned enterprises, not because of it.

Yet the failures of the financial and housing markets in the lead-up to the crisis (failures partly induced by bad government policies and poor regulatory oversight) do 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.

People often mention China’s form of state capitalism as an alternative to competitive capitalism. China has had an astounding economic record during the past thirty years, but the most productive and dynamic part of its economy is the private sector. Chinese growth started in the late 1970s when farming was opened to the private sector, and the private share of economic output has steadily increased. Public enterprises are still important, but China has grown despite the importance of state-owned enterprises, not because of it.

Capitalism lost prestige because of the severity of the Great Recession, but so did governments. Defects in the financial and housing markets can be corrected to a significant extent. More important, history shows that competitive capitalism has been the only path for countries to reduce poverty and sustain long-term growth. The great majority of countries, both developing and developed, will remember this fundamental reality as the world pulls out of the Great Recession.