Published Jun 13, 2009
From the magazine
issue dated Jun 22, 2009
A specter
is haunting the world—the return of capitalism. Over the past six months,
politicians, businessmen and pundits have been convinced that we are in the
midst of a crisis of capitalism that will require a massive transformation and
years of pain to fix. Nothing will ever be the same again. "Another ideological
god has failed," the dean of financial commentators, Martin Wolf, wrote in the
Financial Times. Companies will "fundamentally reset" the way they
work, said the CEO of General Electric, Jeffrey Immelt. "Capitalism will be
different," said Treasury Secretary Timothy Geithner.
No economic system ever
remains unchanged, of course, and certainly not after a deep financial collapse
and a broad global recession. But over the past few months, even though we've
had an imperfect stimulus package, nationalized no banks and undergone no grand
reinvention of capitalism, the sense of panic seems to be easing. Perhaps this
is a mirage—or perhaps the measures taken by states around the world, chiefly
the U.S. government, have restored normalcy. Every expert has a critique of
specific policies, but over time we might see that faced with the decision to
underreact or overreact, most governments chose the latter. That choice might
produce new problems in due course—a topic for another essay—but it appears to
have averted a systemic breakdown.
There is still a long road ahead. There
will be many more bankruptcies. Banks will have to slowly earn their way out of
their problems or die. Consumers will save more before they start spending
again. Mountains of debt will have to be reduced. American capitalism is being
rebalanced, reregulated and thus restored. In doing so it will have to face up
to long-neglected problems, if this is to lead to a true recovery, not just a
brief reprieve.
Many experts are convinced that the situation cannot improve
yet because their own sweeping solutions to the problem have not been
implemented. Most of us want to see more punishment inflicted, particularly on
America's bankers. Deep down we all have a Puritan belief that unless they
suffer a good dose of pain, they will not truly repent. In fact, there has been
much pain, especially in the financial industry, where tens of thousands of
jobs, at all levels, have been lost. But fundamentally, markets are not about
morality. They are large, complex systems, and if things get stable enough, they
move on.
Consider our track record over the past 20 years, starting with the
stock-market crash of 1987, when on Oct. 19 the Dow Jones lost 23 percent, the
largest one-day loss in its history. The legendary economist John Kenneth
Galbraith wrote that he just hoped that the coming recession wouldn't prove as
painful as the Great Depression. It turned out to be a blip on the way to an
even bigger, longer boom. Then there was the 1997 East Asian crisis, during the
depths of which Paul Krugman wrote in a Fortune cover essay, "Never in
the course of economic events—not even in the early years of the Depression—has
so large a part of the world economy experienced so devastating a fall from
grace." He went on to argue that if Asian countries did not adopt his radical
strategy—currency controls—"we could be looking at?.?.?.?the kind of slump that
60 years ago devastated societies, destabilized governments, and eventually led
to war." only one Asian country instituted currency controls, and partial ones
at that. All rebounded within two years.
Each crisis convinced observers that
it signaled the end of some new, dangerous feature of the economic landscape.
But often that novelty accelerated in the years that followed. The 1987 crash
was said to be the product of computer trading, which has, of course, expanded
dramatically since then. The East Asian crisis was meant to end the happy talk
about "emerging markets," which are now at the center of world growth. The
collapse of Long-Term Capital Management in 1998—which then–Treasury secretary
Robert Rubin described as "the worst financial crisis in 50 years"—was meant to
be the end of hedge funds, which then massively expanded. The technology
bubble's bursting in 2000 was supposed to put an end to the dreams of oddball
Internet startups. Goodbye, Pets.com; hello, Twitter. Now we hear that this
crisis is the end of derivatives. Let's see. Robert Shiller, one of the few who
predicted this crash almost exactly—and the dotcom bust as well—argues that in
fact we need more derivatives to make markets more stable.
A few
years from now, strange as it may sound, we might all find that we are hungry
for more capitalism, not less. An economic crisis slows growth, and when
countries need growth, they turn to markets. After the Mexican and East Asian
currency crises—which were far more painful in those countries than the current
downturn has been in America—we saw the pace of market-oriented reform speed up.
If, in the years ahead, the American consumer remains reluctant to spend, if
federal and state governments groan under their debt loads, if government-owned
companies remain expensive burdens, then private-sector activity will become the
only path to create jobs. The simple truth is that with all its flaws,
capitalism remains the most productive economic engine we have yet invented.
Like Churchill's line about democracy, it is the worst of all economic systems,
except for the others. Its chief vindication today has come halfway across the
world, in countries like China and India, which have been able to grow and pull
hundreds of millions of people out of poverty by supporting markets and free
trade. Last month India held elections during the worst of this crisis. Its
powerful left-wing parties campaigned against liberalization and got their worst
drubbing at the polls in 40 years.
Capitalism means growth, but also
instability. The system is dynamic and inherently prone to crashes that cause
great damage along the way. For about 90 years, we have been trying to regulate
the system to stabilize it while still preserving its energy. We are at the
start of another set of these efforts. In undertaking them, it is important to
keep in mind what exactly went wrong. What we are experiencing is not a crisis
of capitalism. It is a crisis of finance, of democracy, of globalization and
ultimately of ethics.
"Capitalism messed up," the British tycoon Martin
Sorrell wrote recently, "or, to be more precise, capitalists did." Actually,
that's not true. Finance screwed up, or to be more precise, financiers did. In
June 2007, when the financial crisis began, Coca-Cola, PepsiCo, IBM, Nike,
Wal-Mart and Microsoft were all running their companies with strong balance
sheets and sensible business models. Major American corporations were highly
profitable, and they were spending prudently, holding on to cash to build a
cushion for a downturn. For that reason, many of them have been able to weather
the storm remarkably well. Finance and anything finance-related—like real
estate—is another story.
Finance has a history of messing up, from the Dutch
tulip bubble in 1637 to now. The proximate causes of these busts have been
varied, but follow a strikingly similar path. In calm times, political
stability, economic growth and technological innovation all encourage an
atmosphere of easy money and new forms of credit. Cheap credit causes greed,
miscalculation and eventually ruin. President Martin Van Buren described the
economic crisis of 1837 in Britain and America thusly: "Two nations, the most
commercial in the world, enjoying but recently the highest degree of apparent
prosperity and maintaining with each other the closest relations, are
suddenly?.?.?.?plunged into a state of embarrassment and distress. In both
countries we have witnessed the same [expansion] of paper money and other
facilities of credit; the same spirit of speculation?.?.?.?the same overwhelming
catastrophe." Obama could put that on his teleprompter today.
Many of the
regulatory reforms that people in government are talking about now seem sensible
and smart. Banks that are too large to fail should also be too large be
leveraged at 30 to 1. The incentives for executives within banks are skewed
toward reckless risk-taking with other people's money. ("Heads they win, tails
they break even," is how Barney Frank describes the current setup.) Derivatives
need to be better controlled. To call banks casinos, as is often done, is
actually unfair to casinos, which are required to hold certain levels of capital
because they must be able to cash in a customer's chips. Banks have not been
required to do that for their key derivatives contract, credit default
swaps.
Yet at the same time, we should proceed cautiously on massive new
regulations. Many rules put in place in the 1930s still look smart; the problem
is that over the past 15 years they were dismantled, or conscious decisions were
made not to update them. Keep in mind that the one advanced industrial country
where the banking system has weathered the storm superbly is Canada, which just
kept the old rules in place, requiring banks to hold higher amounts of capital
to offset their liabilities and to maintain lower levels of leverage. A few
simple safeguards, and the whole system survived a massive storm.
The
simplest safeguard American regulators have had, of course, is the interest rate
on credit. In responding to almost every crisis in the past 15 years, former Fed
chairman Alan Greenspan always had the same solution: cut rates and ease up on
money. In 1998, when Long-Term Capital Management collapsed, he suddenly and
dramatically slashed rates, even though the economy was roaring along at 6
percent growth. In late 1999, buying into fears about Y2K, he swamped the
markets with liquidity. (One effect: between November 1998 and February 2000,
when rates finally rose, the NASDAQ jumped almost 250 percent, increasing in
value by more than $3 trillion.) And finally, when the technology bubble burst
and 9/11 hit, Greenspan again lowered rates and kept them low, this time
inflating a massive housing bubble.
Greenspan behaved like most American
political leaders over the past two decades—he chose the easy way out of a hard
situation. William McChesney Martin, the great Fed chairman of the 1950s and
1960s, once said that his job was to take the punch bowl away just as the party
had begun. No one wants to do that in America anymore—not the Fed chairman, not
the regulators, not Congress and not the president.
Government actions should
be "countercyclical"—that is, they should work to slow down growth. So, in boom
times, the Fed would raise rates and require banks to have higher capital and
lower leverage. Fannie Mae and Freddie Mac would start worrying about too much
easy credit, raise standards for loans and disqualify buyers unlikely to be able
to afford houses. Banks would be urged to slow down the supply of credit cards
and other credit instruments. In fact, this is exactly how the governments of
China and India behaved in 2007, when their economies were booming. At the peak,
consumption in India actually declined as a percentage of GDP.
In the United
States, the opposite happened: consumption surged from 67 percent to 73 percent
of GDP. Presidents and congressmen extolled the virtues of homeownership for
everyone. Congress pushed Fannie Mae and Freddie Mac to extend more loans.
Regulators eased up on banks, and the Fed kept rates low. And the public cheered
this pandering at every step.
Since Ronald Reagan's presidency, Americans
have consumed more than we produced and have made up the difference by
borrowing. This is true of individuals but, far more dangerously, of governments
at every level. Government debt in America, especially when entitlements and
state pension commitments are included, is terrifying. And yet no one has tried
seriously to close the gap, which can be done only by (1) raising taxes or (2)
cutting expenditures. Any sensible proposal will have to feature both
prominently.
This is the disease of modern democracy: the system cannot
impose any short-term pain for long-term gain. For 20 years, most serious
structural problems—Social Security, health care, immigration—have been kicked
down the road. And while the problem is acute in America, Europe and Japan face
many of the same difficulties. Right now, the U.S. government's boldness is
laudable, but it is being bold in spending money. In a few years, when the bills
come due, and Congress must enact major spending cuts as well as raise taxes
(and not just on the rich), that's when we will see if things have
changed.
In reality, the problem goes well beyond Washington. It also goes
beyond bad bankers, lax regulators and pandering politicians. The global
financial system has been crashing more frequently over the past 30 years than
in any comparable period in history. on the face of it, this suggests that we're
screwing up, when in fact what is happening is more complex. The problems that
have developed over the past decades are not simply the products of failures.
They could as easily be described as the products of success.
Here's why we
got to where we are. Since the late 1980s, the world has been moving toward a
extraordinary degree of political stability. The end of the Cold War has ushered
in a period with no major military competition among the world's great
powers—something virtually unprecedented in modern history. It has meant the
winding down of most of the proxy and civil wars, insurgencies and guerrilla
actions that dotted the Cold War landscape. Even given the bloodshed in places
like Iraq, Afghanistan and Somalia, the number of people dying as a result of
political violence of any kind has dropped steeply over the past three
decades.
Then there is the end of inflation. In the 1970s, dozens of
countries suffered hyperinflation, which destroyed the middle class,
destabilized societies and led to political upheaval. Since then, central banks
have become very good at taming the monster, and by 2007 the number of countries
with high inflation had dwindled to a handful. only one, Zimbabwe, had
hyperinflation.
Add to this the information and Internet revolutions, and you
have a series of historical changes that have produced a single global system,
far more integrated and faster-moving than ever before. The results speak for
themselves. Over the past quarter century, the global economy has doubled every
10 years, going from $31 trillion in 1999 to $62 trillion in 2008. Recessions
have become tamer than ever before, averaging eight months rather than two
years. More than 400 million people across Asia have been lifted out of poverty.
Between 2003 and 2007, average income worldwide grew at a faster rate (3.1
percent) than in any previous period in recorded human history. In 2006 and
2007—the peak years of the boom—124 countries around the world grew at 4 percent
a year or more, about four times as many as 25 years earlier.
Many of these
countries had more cash than they knew what to do with. China sits on a war
chest of more than $2 trillion, while eight other emerging-market nations have
reserves of more than $100 billion. They've all looked to the safest investment
they could imagine—U.S. government debt. In buying so much debt, they drove down
the interest rate Washington had to offer, which in turn made credit in America
cheap. So the effect of all this money sloshing around the world was to
subsidize Americans in their favorite activity: shopping. But it affected other
Western countries as well, from Spain to Ireland, where consumers and
governments loaded themselves up with debt.
Good times always make people
complacent. As the cost of capital sank over the past few years, people became
increasingly foolish. The world economy had become the equivalent of a race
car—faster and more complex than any vehicle anyone had ever seen. But it turned
out that no one had driven a car like this before, and no one really knew how.
So it crashed.
The real problem is that we're still driving this car. The
global economy remains highly complex, interconnected and im-balanced. The
Chinese still pile up surpluses and need to put them somewhere. Washington and
Beijing will have to work hard to slowly stabilize their mutual dependence so
that the system is not being set up for another crash.
More broadly, the
fundamental crisis we face is of globalization itself. We have globalized the
economies of nations. Trade, travel and tourism are bringing people together.
Technology has created worldwide supply chains, companies and customers. But our
politics remains resolutely national. This tension is at the heart of the many
crashes of this era—a mismatch between interconnected economies that are
producing global problems but no matching political process that can effect
global solutions. Without better international coordination, there will be more
crashes, and eventually there may be a retreat from globalization toward the
safety—and slow growth—of protected national economies.
Throughout this
essay, I have avoided treating this economic crisis as a grand morality play—a
war between good and evil in which demon bankers destroyed all that is good and
true about our socie-ties. Complex historical events can rarely be reduced to
something so simple. But we are suffering from a moral crisis, too, one that may
lie at the heart of our problems.
Most of what happened over the past decade
across the world was legal. Bankers did what they were allowed to do under the
law. Politicians did what they thought the system asked of them. Bureaucrats
were not exchanging cash for favors. But very few people acted responsibly,
honorably or nobly (the very word sounds odd today). This might sound like a
small point, but it is not. No system—capitalism, socialism, whatever—can work
without a sense of ethics and values at its core. No matter what reforms we put
in place, without common sense, judgment and an ethical standard, they will
prove inadequate. We will never know where the next bubble will form, what the
next innovations will look like and where excesses will build up. But we can ask
that people steer themselves and their institutions with a greater reliance on a
moral compass.
One of the great shifts taking place in American society has
been away from the old guild system of self-regulation. once upon a time, law,
medicine and accounting viewed themselves as private-sector participants with
public responsibilities. Lawyers are still called "officers of the court." And
historically they acted with that sense of stewardship in mind, thinking of what
was appropriate for the whole system and not simply for their firm. That meant
advising their clients against time-consuming litigation or mindless mergers.
Elihu Root, a leader of the New York bar in the late 19th century, once said,
"About half the practice of a decent lawyer consists in telling would-be clients
that they are damned fools and should stop."
It's not just the law that has
changed; so have all the professions. Ever since the 1930s, accountants have
been given a unique trust. "Who audits you?" asked Sen. Alben Barkley during a
1933 committee hearing. "Our conscience," replied Arthur Carter, the head of a
large accounting firm. But by 2002 The Wall Street Journal was
describing a different world, in which accountants had gone from "watchdogs to
lapdogs," telling clients whatever they wanted to hear. Bankers similarly once
saw themselves as being stewards of capital, responsible to their many
constituents and embodying trust. But over the past few decades, they too became
obsessed with profits and the short term, uncertain about their own future and
that of their company. The most recent example of this phenomenon has been at
the rating agencies, which were generating fees that were too lucrative to be
exacting in their judgments about their clients' products.
None of this has
happened because businesspeople have suddenly become more immoral. It is part of
the opening up and growing competitiveness of the business world. Many of the
old banks and law firms operated as monopolies or cartels. They could afford to
take the long view. They were also run by a WASP elite secure in its privilege.
The members of today's meritocratic elite are more anxious and insecure. They
know that they are being judged quarter by quarter.
The failure of
self-regulation over the past 20 years—in investment banking, accounting, rating
agencies—has led inevitably to the rise of greater government regulation. This
marks an important change in the Anglo-American world, away from informal rules
often enforced by private actors toward the more formal bureaucratic system
common in continental Europe. Perhaps the state should not set the pay of the
private sector. But surely CEOs should exercise some judgment about their own
compensation, and tie it far more closely to the long-term health of the
company. It will still be possible to get very rich—Warren Buffett, after all,
draws a salary of only $100,000.
There's a need for greater self-regulation
not simply on Wall Street but also on Pennsylvania Avenue. We get exercised
about the immorality of politicians when they're caught in sex scandals.
Meanwhile they triple the national debt, enrich their lobbyist friends and write
tax loopholes for specific corporations—all perfectly legal—and we regard this
as normal. The revolving door between Washington government offices and lobbying
firms is so lucrative and so established that anyone pointing out that it is—at
base—institutionalized corruption is seen as baying at the moon. Not everything
is written down, and not everything that is legally permissible is ethical. Who
was the last ex-president to refuse to take a vast donation for his library from
a foreign government that he had helped when in office?
We are in the midst
of a vast crisis, and there is enough blame to go around and many fixes to make,
from the international system to national governments to private firms. But at
heart, there needs to be a deeper fix within all of us, a simple gut check. If
it doesn't feel right, we shouldn't be doing it. That's not going to restore
growth or mend globalization or save capitalism, but it might be a small start
to sanity.
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