Oct 16th 2008 From The Economist print edition
ONE hundred and sixty five years ago, a Scottish businessman set out his plans for a newspaper. James Wilson’s starting point was “a melancholy reflection”: “while wealth and capital have been rapidly increasing” and science and art “working the most surprising miracles”, all classes of people were marked “by characters of uncertainty and insecurity”. Wilson’s solution was freedom. He committed his venture to the struggle not just against the protectionist corn laws but against attempts to raise up “barriers to intercourse, jealousies, animosities and heartburnings between individuals and classes in this country, and again between this country and all others”. Ever since, The Economist has been on the side of economic liberty.
Now economic liberty is under attack and capitalism, the system which embodies it, is at bay. This week Britain, the birthplace of modern privatisation, nationalised much of its banking industry; meanwhile, amid talk of the end of the Thatcher-Reagan era, the American government has promised to put $250 billion into its banks. Other governments are re-regulating their financial systems. Asians point out that the West appears to be moving towards their more dirigiste model: “The teachers have some problems,” a Chinese leader recently said. Interventionists are in full cry: “Self-regulation is finished,” claims France’s Nicolas Sarkozy. “Laissez-faire is finished.” Not all criticisms are that unsubtle (the more pointed ones focus on increasing the state’s role only in finance), but all the signs are pointing in the same direction: a larger role for the state, and a smaller and more constrained private sector.
This newspaper hopes profoundly that this will not happen. Over the past century and a half capitalism has proved its worth for billions of people. The parts of the world where it has flourished have prospered; the parts where it has shrivelled have suffered. Capitalism has always engendered crises, and always will. The world should use the latest one, devastating though it is, to learn how to manage it better.
Extreme measures in the defence of liberty
In the short term defending capitalism means, paradoxically, state intervention. There is a justifiable sense of outrage among voters and business people (and indeed economic liberals) that $2.5 trillion of taxpayers' money now has to be spent on a highly rewarded industry. But the global bail-out is pragmatic, not ideological. When François Mitterrand nationalised France’s banks in 1981 he did so because he thought the state would run them better. This time governments are buying banks (or shares in them) because they believe, rightly, that public capital is needed to keep credit flowing.
Intervening to prevent banking crises from hurting the real economy has a strong pedigree. Wilson’s son-in-law, Walter Bagehot, recommended that the Bank of England lend generously (but at a penalty rate) to illiquid banks (but not to insolvent ones). In modern times governments of every political stripe have had to step in. Ronald Reagan and Margaret Thatcher oversaw the rescues of Continental Illinois and Johnson Matthey. In the 1990s the Finns and Swedes nationalised banks—and privatised them again later. This rescue is on a different scale. Yet the justification is the same: the costs of not intervening look larger. If confidence and credit continue to dry up, a near-certain recession will become a depression, a calamity for everybody.
Even if it staves off disaster, the bail-out will cause huge problems. It creates moral hazard: such a visible safety net encourages risky behaviour. It may also politicise lending.
Governments will need to minimise these risks. They should avoid rewarding the bosses and shareholders of the rescued banks. They must not steer loans to politically important sectors. And they should run the banks on a commercial basis with the explicit aim of getting out of the banking business as quickly as possible (and at a profit). From the taxpayer’s point of view, it might make sense to limit dividend payments to other shareholders until the government’s preference shares have been paid off. But governments need to avoid populist gestures. Banning bonuses, for instance, would drive good people out of companies that badly need them.
The politicians all claim they understand this. Of course, they have no intention of revisiting Mitterrand’s mistakes, of trying to run the banks themselves, or of taking stakes elsewhere. Yet already voices (including Lady Thatcher’s Tory heirs) are pushing to limit executive pay. It will be a brave president who goes to Detroit and explains why the 45,000 well-paid folk at Morgan Stanley should get $10 billion of taxpayers' money, but the 266,000 people at General Motors should not. Brave too would be any politician who proposed deregulation as a solution to a public-sector problem.
Smoot-Hawley in the rear mirror
Given this, it is inevitable that the line between governments and markets will in the short term move towards the former. The public sector and its debt will take up a bigger portion of the economy in many countries. But in the longer term a lot depends on how blame for this catastrophe is allocated. This is where an important intellectual battle could and should be won. Capitalism’s defenders need to deal with two sorts of criticism. One has much more substance than the other.
The weaker, populist argument is that Anglo-Saxon capitalism has failed. Critics claim that the “Washington consensus” of deregulation and privatisation, preached condescendingly by America and Britain to benighted governments around the world, has actually brought the world economy to the brink of disaster. If this notion continues to gain ground, politicians from Beijing to Berlin will feel justified in resisting moves to free up the movement of goods and services within and between their economies. Arguments for market solutions in, for instance, health and education will be made with less conviction, and dismissed with a reference to Wall Street’s fate.
In fact, far from failing, the overall lowering of “barriers to intercourse” over the past 25 years has delivered wealth and freedom on a dramatic scale. Hundreds of millions of people have been dragged out of absolute poverty. Even allowing for the credit crunch, this decade may well see the fastest growth in global income per person in history. The free movement of non-financial goods and services should not be dragged into the argument—as they were, to disastrous effect, in the 1930s.
A second group of critics focuses on deregulation in finance, rather than the economy as a whole. This case has much more merit. Finance needs regulation. It has always been prone to panics, crashes and bubbles (in Victorian times this newspaper was moaning about railway stocks, not house prices). Because the rest of the economy cannot work without it, governments have always been heavily involved.
Without doubt, modern finance has been found seriously wanting. Some banks seemed to assume that markets would be constantly liquid. Risky behaviour garnered huge rewards; caution was punished. Even the best bankers took crazy risks. For instance, by the end of last year Goldman Sachs, by no means the most daring, had $1 trillion of assets teetering atop $43 billion of equity. Lack of regulation encouraged this gambling (see article). Financial innovation in derivatives soared ahead of the rule-setters. Somehow the world ended up with $62 trillion-worth of credit-default swaps (CDSs), none of them traded on exchanges. Not even the most liberal libertarian could imagine that was sensible.
Yet the failures of modern finance cannot be blamed on deregulation alone. After all, the American mortgage market is one of the most regulated parts of finance anywhere: dominated by two government sponsored agencies, Fannie Mae and Freddie Mac, and guided by congressional schemes to increase home-ownership. The macro economic condition that set up the crisis stemmed in part from policy choices: the Federal Reserve ignored the housing bubble and kept short-term interest rates too low for too long. The emerging world’s determination to accumulate reserves, especially China’s decision to hold down its exchange rate, sent a wash of capital into America. There was something of a perfect storm in which policy mistakes combined with Wall Street’s excesses.
Heavy regulation would not inoculate the world against future crises. Two of the worst in recent times, in Japan and South Korea, occurred in highly rule-bound systems. What’s needed is not more government but better government. In some areas, that means more rules. Capital requirements need to be revamped so that banks accumulate more reserves during the good times. More often it simply means different rules: central banks need to take asset prices more into account in their decisions. But there are plenty of examples where regulation could be counter-productive: a permanent ban on short-selling, for instance, would make markets more volatile.
Indeed, history suggests that a prejudice against more rules is a good idea. Too often they have unintended consequences, helping to create the next disaster. And capitalism, eventually, corrects itself. After a crisis investors (and for that matter regulators) seldom make exactly the same mistake twice. There are, for instance, already plans for clearing houses for CDSs.
Turning back the incoming tide
Sadly another lesson of history is that in politics economic reason does not always prevail—especially when the best-case scenario for most countries is a short recession. “Barriers to intercourse, jealousies, animosities and heartburnings” loom.
But it need not be so. If the bail-outs are well handled, taxpayers could end up profiting from their reluctant investment in the banks. If regulators learn from this crisis, they could manage finance better in the future. If the worst is avoided, the healthy popular hostility to a strong state that normally pervades democracies should reassert itself. Capitalism is at bay, but those who believe in it must fight for it. For all its flaws, it is the best economic system man has invented yet.
