No other system in history has been able to raise material living conditions for so many people as much as capitalism has done. Having said that, capitalism is a system that contains a constant potential for conflict: conflict between the market and the state; between the group and the individual; and between ‘winners’ and ‘losers’ in the market process. The market mechanism is undoubtedly a very efficient allocation mechanism. There are, however, two major problems associated with it. First, the market sometimes fails. And second, the market sometimes provides results that are not acceptable, either for social, political, or other reasons. It is the role of the state to make sure markets can function properly and to take corrective action when they fail or produce unacceptable results. At times, the various conflicts cannot be resolved in a satisfactory manner and the system becomes seriously imbalanced.
Capitalism is an adaptive system that evolves over time. When a serious imbalance occurs, the system can go through a major transformation. After the depression of the 1930s such a transformation took place. The role of the state was increased, macro stabilisation policies became commonplace, workers’ rights were strengthened and income distribution became more equitable, partly through the tax system. After some time, however, another crisis hit – the stagflation of the 1970s. The post-war economic system was unable to cope with the challenges it faced and so another big transformation occurred. The Thatcher-Reagan revolution reduced the power of unions and tried to increase the growth potential of the economy by liberalisation, deregulation and more emphasis on market forces. This system gradually evolved into neo-liberalism. Confidence in markets increased at the expense of appreciation for the public sector, and markets were given more and more room to develop. Paradoxically, the public sector did not get much smaller during this period. At the micro level, the aim of companies was narrowed down to creating shareholder value. The crisis of the last couple of years has revealed that the neo-liberal form of capitalism has run into problems. People feel disillusioned with ‘the market’. Inequality has risen in many countries to a level that leads to social disengagement. Excesses in the financial sector have undermined confidence in financial institutions. The crisis in the financial sector is a symptom of the crisis of neo-liberalism. Enormous challenges lie ahead, ageing, health care, environment, energy, food (safety), water. Neo-liberal capitalism is unlikely to find answers to all these challenges. Another fundamental transformation of capitalism is upon us. Governments and the market must find each other again as partners, as natural complements of a vibrant capitalism, not enemies. Government must re-define its role. It can and must play a greater role in fostering economic growth. It must recalibrate the incentive structure of the welfare system. Yet, given its size, government must get smaller, not larger. The market must broaden its horizon. The lopsided focus on shareholder value is a thing of the past. If government and the market are to be each other’s partners, the market must take on increasing social responsibilities.
Capitalism is resilient, it will survive. Any transformation is difficult and the period ahead promises to be challenging and confusing. Established interest will, unsuccessfully, defend the status quo. It would be more constructive to embrace the necessary change. A number of changes that we need have been set in motion. I am confident that we will succeed.
When the credit bubble burst in 2007/2008 and it became obvious that the world economy was at serious risk, I re-read literature I had studied in the past about financial crises, from Kindleberger to Minsky. I also thought about what I remembered other economists had written, from Marx to Von Mises, Hayek, Keynes and Schumpeter. This refreshed knowledge gave me confidence about analysing and predicting how things might evolve. However, I was completely caught out by two aspects of the crisis. First, I did not at all, perhaps naively, anticipate the complete collapse of confidence in and respect for banks (and bank employees, for that matter). The second thing I failed to anticipate fully was the diverse nature of people’s assessment of the causes of and solutions for the crisis. For example, one acquaintance argued that the crisis would inevitably lead to a significant dismantling of the welfare state and to much smaller government. Others argued the opposite, that we need much more government. In their view, the crisis shows that the market economy has failed. In this paper I want to explore the question whether or not and to what extent and in what direction the crisis is likely to change our capitalist economic system.
Even after preparing for this paper I still have many questions, some of which are almost too politically incorrect for a bank employee to raise at this point in time. One of the more pertinent ones, is why my two best friends, one of them a lawyer working for the Dutch government, the other (also working in the public sector) a geographer who became an IT specialist and then moved into HR, are so surprised and indignant that we got hit by this financial crisis. Their approach to the current crisis is: “let’s find the culprits (’and we have a good idea who that might be’), lock them up, throw away the keys, problem solved”. They seem to think that we have a basic right to live our lives without financial crises. When I consider the financial developments during my working life so far, I see little justification for such an expectation. When I joined the financial services industry in 1984, the Latin American debt crisis had just started two years earlier and the number of countries in crisis was still rising. Before too long half the Savings and Loan banks in the US went bust. Then, the huge Japanese property and equity bubbles burst, starting in 1990. The early ’90s were characterised by a recession triggered by the rise of the oil price following the first Gulf War and the aftermath of the overheating related to German reunification. At the same time, several Nordic countries in Europe experienced a significant banking crisis. The ERM crisis hit in 1992/1993. The sharp devaluation of the Mexican peso in December 1994 triggered the Tequila crisis. The Asian crisis then erupted in 1997, triggering several other problems as well, such as the rouble crisis in 1998. The internet bubble burst in 2000 and the peso crisis in Argentina and that country’s default followed quickly in 2001. This list is not exhaustive. Over this twenty-year period there have been many smaller, local financial crises as well. In any event, it is fair to say that the twenty years starting in 1982 were littered with financial shocks and crises, many of which had serious international dimensions. Is it devious irony that economists refer to this period as the “Great Moderation”? Of course, the theory of the Great Moderation does not look specifically at financial shocks but at overall macroeconomic volatility in a number of key economies. Suffice it to say that my best friends, who are so shocked by the current financial crisis, seem to have felt and based their expectations on the effects of the Great Moderation but appear to have been completely oblivious to the large number of crises over the last thirty years. Admitted, most of these crises had relatively little impact on their own comfort zones.
Thinking about capitalism
I am well aware that my readers are familiar with the writings of past philosophers, moralists and economic thinkers. Nonetheless, it might be no harm for us to recall some of their ideas, particularly regarding economic systems. I have grouped thinkers before Adam Smith in box 1, below, which may make it easier to decide to skip that part.
When reviewing what philosophers, political scientists and economists have said about capitalism through the ages, I am struck by three things. First, today’s discussions about our economic system resemble to some extent discussions from the past. It is therefore interesting to listen to history. Second, economic thinkers usually respond to thinkers before them with whom they do not agree. They subsequently often go to an extreme, provoking others to form a new school of thought. Third, economic thinkers do not usually ‘lead’ but, instead, ‘follow’ and respond to changes in economic reality.
Before reviewing what thinkers in the past have said about capitalism, we need a definition. There are many definitions possible and capitalism comes in many shapes and forms. But it is probably fair to say that capitalism is an economic system that is characterised by private property, by the exchange among legally free individuals, while production and distribution are directed by a market mechanism. Ambition, initiative, individualism and competitive spirit are key ingredients.
The coexistence of the market economy and the state is a source of potential tension, as is the tension between the interest of the individual versus the interest of the group. Conflicting interests of different groups in a market economy can also lead to tension as a competitive process can have winners and losers. From time to time tension builds to such an extent that a process of significant change is triggered. Capitalism is an adaptable system that has evolved over time.
Box 1. A very brief history of thinking about commerce, markets and capitalism before Adam Smith. Although they were economically successful, the Greeks and the Romans distrusted commerce. Aristotle, for example, felt that the pursuit of money had no natural end to it. In fact, he believed that it tends to lead to excesses (sounds familiar?), in contrast to agriculture. For the Greeks and the Romans the highest that humans could aim for were civic virtues, in particular fighting for the republic and governing. Through the Middle Ages the Christians were also hostile to commerce as they considered the pursuit of riches a threat to salvation. The biblical basis for this is not hard to find. “It is easier for a camel to go through the eye of a needle than for a rich man to enter the kingdom of God” is a phrase that can be found in three Gospels (Matthew, Mark and Luke).
An increase in agricultural production in the 13th century led to a minor commercial revolution and the church changed its tone a little. It tolerated and perhaps encouraged the formation of professional associations – guilds. Any concept of social mobility remained absent, however. One should only aspire to one’s fair share, one’s traditional share. It really wasn’t until the 17th century that economic and political thinking changed dramatically. Thomas Hobbes (1588-1679) argued that government should not decide for the people what the higher purpose in life is, be it either civic virtues or salvation. Peace, prosperity and intellectual development were his ideal. Self-interest as a legitimate driver of human behaviour comes through in his work. Enabling worldly happiness should be the purpose of government. Hobbes set the stage for John Locke (1632-1704), the father of liberalism, who believed that the role of the state should be to protect its citizens and allow them to pursue the goals they consider the highest.
The 17th century was the time of Dutch economic power. The Dutch East India Company was the first enterprise in the world to issue shares (1602), which were traded on the first stock exchange in the world. It was probably no coincidence that the economically most successful country in Europe was also the most tolerant religiously. Amsterdam was a multi-cultural, multi-lingual city. Holland’s success led European thinkers to reconsider their civic-republican and Christian traditions and adopt a more commercial dimension. The interaction between commerce and national power was characteristic for the Dutch Republic. The phrase ‘political economy’ was born (in France, 1615).
The 18th century was the age of the Enlightenment. Printing techniques had evolved from their 15th century invention to allow the large scale production and distribution of books. This led to the increasing importance of ‘public opinion’. Voltaire (1694-1778) stressed the legitimacy of material consumption. In addition, he recognised that the pursuit of wealth through market activity could have important political benefits. A financial revolution played out. The Bank of England was founded in 1694, tax collection became common and a market for state debt emerged. The public, however, responded with suspicion. People trading on the London Stock Exchange were often referred to as ‘gamblers, money grabbers and speculators’. It would seem that ‘speculators’ have survived and are still alive and kicking as a popular, multi-purpose culprit.
Moralists objected to the pursuit of individual well-being as this pursuit was considered to be at the expense of the common good. Rousseau (1712-1778) developed a critique of the evolving ‘commercial society’, which, he believed, was leading to a corruption of morals. The rise in living standards was leading to new desires, distracting people from moral purposes. Private property was evil as it leads to inequality and thus is a source of misery. The common interest must be given a higher priority, according to Rousseau, than individual interests. Voltaire and Hume responded to Rousseau wondering if Rousseau’s obsession with equality wasn’t a recipe for collective poverty. This 18th century discussion is as relevant today as it was then.
Adam Smith (1723-1790) is usually seen as the founding father of theoretical capitalism, or as the advocate of free markets. The goal of the market economy, in his view, is the ongoing rise in the standard of living of the vast majority of the population. He analysed how a system in which people are mainly driven by self-interest provides good results in this respect. This view can hardly be captured better than in his own words: ” It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”. That said, Smith realised that people have other drivers beside self-interest, as he eloquently phrased in the first sentence of his Theory of Moral Sentiments: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”
In contrast to what is sometimes argued, Smith did not advocate a blind faith in markets. He showed that the pursuit of self-interest does not automatically and universally lead to the public benefit. Markets need to be structured and regulated. Smith saw that the outcome of a market process could be suboptimal or simply not acceptable if certain participants had a disproportionate amount of power on the market. He favoured a well-functioning government that would provide what the market couldn’t and that would make sure that markets functioned optimally. The government was responsible for, among other things, infrastructure and education. The state also had to protect property rights. As the rich benefit more from that than the poor, Smith found it reasonable that the rich should pay more tax. He also saw the potential tensions in a market economy: “…the affluence of the rich excites the indignation of the poor”.
Subsequent thinkers focussed on the position of the individual in the commercial society. Others concentrated more on the question how to make capitalism better, more productive. The US’s first Treasury Secretary, Alexander Hamilton (1755-1804) stressed the need for a strong national government. His Federalist Papers, a blueprint for the growth strategy of the young United States, contained many elements seen in the growth strategy of many emerging economies nowadays. There was a clearly defined role for government in Hamilton’s economic plans, ranging from protecting domestic sectors to playing an active role in the development of certain sectors.
Capitalism’s first big transformation
The industrial revolution led to significant economic growth, but also to hardship among the working class. The circumstances under which many people had to work were appalling and the work they were doing could hardly have given them any intellectual or other satisfaction. It is no surprise that this led to criticism. Karl Marx believed that capitalism was full of inconsistencies and would end in crisis. This would trigger a revolutionary change, paving the way for a classless society. Just to make sure, he formulated two crisis theories. Capitalism would go down because of a lack of demand due to an extremely unequal distribution of income and as a consequence of a falling profit rate. Marx did, however, recognise the great achievements of capitalism. He recognised its dynamism and the significant growth it had brought.
But Marx was proven wrong on the inevitability of revolution. Capitalism doesn’t break, it bends. Contrary to what Marx believed, workers’ wages did not fall to subsistence level, but started to climb while working conditions improved. And the lack of demand Marx expected, proved not chronic but incidental. Nevertheless, as we know, ‘professional revolutionaries’ established a communist regime in Russia, and other countries followed. The communist regimes were characterised by a lack of economic freedom and a lack of political freedom, but a certain degree of material security, often after an initial period of chaos.
Western thinkers such as Hayek, Schumpeter and Von Mises later made the connection between capitalism and freedom, or democracy, or rather between socialism and lack of freedom. It was clear, though, that capitalism also had negative consequences and it needed to change. It needed to adapt to the growing wish for economic security and stability in people’s lives and respond to the threat of socialism which seemed to provide for greater security and fairness. This response consisted of several elements. Workers’ rights were strengthened, redistributive taxes were introduced, the development of a social safety net started and government spending was raised. Keynes provided the theoretical backing for macroeconomic stabilisation policies.
This new phase of capitalism was successful, particularly after World War II, in terms of generating economic growth and providing stability. Sadly, this period of solid growth, full employment, increasing workers’ rights etc. ended in stagflation in the 1970s. The Vietnam war caused significant financial stress on the US government as did the growing social programmes, which also increased significantly in Europe. Monetary policy was accommodative. At the same time trade unions became increasingly self-confident and militant. Perhaps one can argue that this phase of capitalism became the victim of its own success. The success of economic policies implied high, sustained employment numbers and steadily rising real income levels. No wonder that workers became more self-confident. This is perhaps the ‘real economy’s equivalent’ of Hyman Minsky’s financial instability hypothesis. The oil price shock of the early 1970s pushed up inflation further, sealing the fate of this period of capitalism.
The second big transformation of capitalism
Adverse economic conditions forced capitalism to adapt again and it did. Following the (in)famous winter of discontent in the UK, Margaret Thatcher won the 1979 general elections and Ronald Reagan was elected President of the US a year later. They steered the capitalist system in a different direction, giving the market a much more dominant position at the expense of government and unions. Perhaps one could also say that ‘capital’ was rehabilitated relative to ‘labour’. Milton Friedman (and other economists, of course) provided the theoretical economic foundation.
Even now it is hard to say with certainty what exactly explained the success of the Reagan-Thatcher era. Paul Volcker’s Fed killed inflation quickly, though at the expense of a deep recession and high unemployment. This certainly put paid to over-confidence on the part of workers and unions. Interestingly, despite the rhetoric, the Fed moved away from its extreme-monetarist policies relatively quickly. Volcker suspended money targets in August 1982. Officially, the Fed’s road to success continued to be based on maintaining price stability. In reality, however, economic policy moved back to a more subtle version of demand management. Monetary policy took over some of the responsibilities of fiscal policy in this respect. The rhetoric in Europe was more pertinent and to this day the ECB’s mandate consists of price stability only (and financial stability). However, the actions of the ECB and its effective predecessor, the Bundesbank, show that monetary policy in Europe was also much more pragmatic than officially professed and served demand management at times.
Deregulation and supply-side improvements undoubtedly contributed importantly to improving growth. But the victory against inflation, the gain in confidence and stability and the drop in borrowing costs that implied were arguably the decisive factors.
Neo-liberalism and the crisis
The fundamental elements of this new phase of capitalism were nicely summarised by John Williamson in the ‘Washington Consensus’ he formulated in 1989. From here the system gradually developed into neo-liberalism, which is characterised by a distrust of government intervention in markets and an extreme faith in free, laissez faire markets. “The market knows best”. Former Fed chairman Alan Greenspan was perhaps the personification of this. He was a strong believer in the free market – the freer, the better. Competition drives progress. Greenspan did acknowledge that the process of competition isn’t always pleasant, which he succinctly expressed in his autobiography: “While competition is essential to economic progress, I can’t say I always personally enjoy the process. I never thought kindly of rival firms seeking to lure clients from Townsend-Greenspan. But to compete, I had to improve. I had to offer a better service. I had to become more productive. In the end, of course, I was better off for it”. Greenspan was a follower of Ayn Rand (1905-1982), the best-selling Russian/American novelist and philosopher, whose philosophy caught on in the US but not very much in Europe. Rand grew up in Russia, but moved to the US in 1926. She developed a philosophy which she called ‘objectivism’ and which sees the pursuit of one’s own happiness as the proper moral purpose in life. Her dislike of anything related to collectivism is surely a reaction to her experience in Russia after the revolution of 1917. Her extreme views were clearly a brigde too far for most Europeans.
Greenspan’s faith in markets defined his approach to central banking. In the area of regulation, he favoured ‘regulation-light’. Other contemporary policymakers held similar beliefs, and a period of financial liberalisation took place from the early 1990s on. Greenspan was convinced that supervisors could not keep up with developments in financial institutions and would therefore always be behind the curve. He felt that it was OK to rely heavily on the self-interest of senior management in banks. But before a Congressional committee in October 2008, Greenspan said: “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms. Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief.”
Contrary to what Greenspan had assumed, banks’ management did not pursue the interests of all stakeholders. At the company level, neo-liberalism is characterised by an increasing focus on shareholder value. The idea is that maximising shareholder value provides the best results for everybody. It has become clear, however, that the interests of all stakeholders were not sufficiently aligned to achieve this.
Greenspan had also developed a libertarian, hands-off approach as far as alleged bubbles on financial markets were concerned. He had been convinced that central bankers could not know better than market participants what the right valuation of assets is. In addition, from experience he had concluded that it was difficult, if not impossible for the Fed to let air out of a building bubble. Greenspan believed that instead of trying to identify a bubble and deflating it, the central bank should limit itself to ‘cleaning up’ if and when a bubble burst.
The Great Moderation, the period of less macroeconomic volatility in a number of key economies, implied increased stability and thus less risk. Against this background, it was therefore completely logical and rational that overall borrowing in these countries should increase. It was reasonable and rational for policymakers to tolerate this. Financial innovation played a role as well. An increasing number of people and companies gained access to instruments that allowed them to manage their finances better. After the US housing market crashed and people ended up with negative equity, the financial sector was criticised for allowing people to use their home as a virtual ATM. That is not entirely fair. A home is an illiquid asset. Finance had turned it into a more liquid asset. Surely that must enable us to improve economic efficiency, though clearly not without risk.
Admitted, it is virtually impossible to calculate what an optimal level of total gross indebtedness is in the economy as a whole. So the authorities could not know whether or not too much debt was being created. What one can say, though, is that the combination of increased stability, and thus lower risk, and Greenspan’s (and other policymakers as well, of course) neo-liberal views contributed to the build-up of debt that financed the housing bubble.
Europe, meanwhile, was building its own ‘bubble’. The arrival of the euro was followed by a strong rise in capital flows between eurozone members. Investors in core countries were searching for yield in peripheral countries. The inflow of capital was welcome for the recipients as it pushed borrowing costs lower and provided funding for growth. Unfortunately, the funds were often used for consumption and for driving up the property sector – not a sustainable basis for growth. The credit bubble burst in 2007/2008. In the US, the bubble was concentrated in sub-prime mortgages. In Europe in sovereign debt.
Box 2: Bubbles
Economic literature about economic bubbles and their bursting is rich and usually makes for fascinating reading. What strikes me about such literature is that it tends to focus strongly on the build-up of the bubble and then its demise, typically neatly dividing the process into separate phases. So the focus tends to be on the mechanics of the process. Surprisingly little is written about the role of bubbles in our economies. I would argue that bubbles provide a lot of dynamism to our economies. I see them as more positive than many think, unless they become too numerous and too large in which case the bursting of one or more bubbles causes a lot of pain. Standard literature is, as far as I am aware, also a little short on how a bubble affects the bigger development of which it tends to be a part. In 1637, the tulip bubble in Holland burst. Arguably, the tulip bubble represented a desire to own Dutch assets as Holland developed into a major power. The bursting of the bubble did not end that process. Quite the opposite – Holland’s power continued to rise for decades. The same happened to the South Sea bubble, which can perhaps be seen as the more sensible version of the Dutch tulip bubble. Buying shares in the South Sea Company was perhaps a proxy for buying a share in the likely rise of the British empire. The share price collapsed in 1720. That was not the end of British hegemony. In fact that was still the early stages of rising British power. More recently, the internet bubble burst in 2000. That was soon after the general public had started using the internet in the course of the 1990s. The collapse of the Nasdaq did clearly not end the internet era. On the contrary, the bursting of the equity bubble happened at an early stage in the development of the internet. The most logical explanation for the course of events in these examples is that markets find it very difficult to assess the value of new assets and they sometimes get over-excited. However, there usually is an rational or at least understandable element to the early stages of the building of a bubble, despite accusations of euphoria. In the case of the internet, the general perception was that it would lift future economic growth. The stock market reflects the present value of corporate profits. If we ‘suddenly’ decide that future economic growth will be higher than we thought until that moment, which was the case towards the end of the 1990s, and we assume that corporate profits will also be higher, it then makes sense for the stock market to adjust sharply as the present value of profits has ‘suddenly’ risen. The logical and rational rise in equity prices is then seen as evidence that the new line of thinking is correct and rising equity prices become self-sustaining. Well, for a while. The point in relation to the credit bubble is that the bursting of the bubble need not be the end to the further sophistication of the offering of financial services.
Still confused at two levels about the causes of the crisis
There is broad consensus that excessive risk taking in the financial sector led to the crisis and that tighter capital and liquidity supervision are an important part of building a more stable system. I have no issues with that. But there is also a more macroeconomic aspect to the causes of the crisis. Persistent, large and growing international payment imbalances were an important feature of the global economy after the turn of the century. Asian countries in particular decided that they needed to build up reserves to prevent a repeat of the Asia crisis. In order to build up reserves they needed to run surpluses on their balance of payments. This implied that other countries had to run deficits, with the US volunteering to be champion. For the US to run external deficits it needed a steady net inflow of capital. As a large part of this capital inflow necessarily had to take the form of debt, some sectors in the US simply had to raise their indebtedness. So the strategy of some nations to build up reserves and the increasing indebtedness of some sectors of the US economy are two sides of the same coin. The reason I am writing this is that I am still wondering if you can somehow address one side of the coin and not the other. What would happen in a world in which large international payment imbalances persist but liquidity and capital ratios in banks are raised? Would that prevent persistent imbalances? And would it prevent the situation exploding or would it make the ultimate explosion only even more devastating? The truth is that I do not know. What I do know, however, is that one-sided focus on the robustness of financial institutions addresses only part of the problem. At least for now, this isn’t really an urgent issue. Payment imbalances have been sharply reduced as some deficit countries have experienced recession and competitiveness in deficit countries has improved through movement of the real effective exchange rate. But these imbalances can easily come back. Or can they?
What also still confuses me about the crisis, and this will bring me back to the original focus of this paper, is how the bursting of the US housing bubble almost brought the global financial system down. My assertion is that the extreme neo-liberal views of the main policymakers in the US are key. Sure, the US housing market was overvalued, but a cumulative correction from the absolute peak of some 30% over a period of four to five years isn’t really that dramatic. There are probably two explanations why the bursting of the housing bubble had such a disproportionately large impact on the global financial system, both related not only to irresponsible banking practices but also to the neo-liberal view of the policymakers. Financial deregulation created room for the build-up of significant leverage in the system, which the central banks tolerated. The result was that many financial connections became linked to the US housing market. Shortly before the crisis erupted, Greenspan wrote: “I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk and that subsidized homeownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened homeownership are worth the risk.”
The second factor was the policy response. If you accept that market economies are prone to boom-bust cycles and that policymakers are responsible for maintaining stability, you will agree that policymakers must intervene when oscillations go out of control. In such circumstances, government intervention is not a favour, it is an essential element of government. Our financial system, including our money, is based on confidence. Confidence can disappear, be it for rational or seemingly irrational reasons. The government is the provider of confidence of last resort. It really is that simple. That, of course, does not excuse financial institutions for taking irresponsible positions. But when it came to 2008 those positions had been taken and it was up to policymakers to ensure that confidence was maintained. Several major mistakes were made – with very negative consequences.
Previous crises had taught some important lessons that were ignored in the recent turmoil. Since Milton Friedman and Anna Schwartz wrote their seminal work on the monetary history of the US in the 1960s, experts had agreed that letting many banks collapse was a significant policy mistake in the 1930s that contributed to turning a recession into a depression. One cannot argue that many relevant banks failed this time around, but the way the US government dealt with Fannie Mae and Freddie Mac was not helpful to maintain confidence to say the least, and letting Lehman fail was clearly a bridge too far. The international debt crisis of the 1980s had shown that the financial system can cope with such shocks if given time to heal. The mark-to-market accounting rules introduced much later do not allow for such a strategy. From a macroeconomic perspective, mark-to-market accounting is a mistake. It amplifies the boom-bust cycle. During good times, asset values rise giving the possibly false impression of value creation. Capital ratios look much better on paper than they really are. This encourages further lending and investing by financial institutions. When bad times arrive, the opposite happens. Capital ratios are suddenly not what they were thought to be. Banks are forced to tighten credit standards and the down leg in the economic cycle is reinforced.
Policymakers were to a large degree in uncharted territory and it is perhaps a little unfair to label some policy decisions as mistakes. Still, I think that the way the US policymakers dealt with the Fannie Mae and Freddie Mac was a policy mistake. There was deep distrust and dislike within Republican ranks regarding these two Government Sponsored Enterprises (GSEs). When the (Republican) Treasury Secretary, Hank Paulson, saw an opportunity to take control of them, he did. The two GSEs were obviously under pressure, but not to the extent that justified the actions taken by the Treasury Secretary. It is hard to see why he wiped out shareholders in both organisations. This not only rewarded the ‘speculators’ who were betting against them, it also hurt overseas investors who had assumed they would have been covered by an implicit government guarantee. As we know, this is the big dilemma for policymakers. They have to weigh up the risk of creating moral hazard against the risk of financial instability and all this against a background of increasingly hostile public opinion. How much financial instability are policymakers willing to risk in their efforts to fight moral hazard?
Up until the summer of 2008, things had been progressing in a reasonably orderly fashion. Banks under pressure successfully sought recapitalisation. Sovereign wealth funds in Asia and the Middle East bought or increased their interests in US financials. When Bear Stearns got in trouble, it was sold with the support of the government and the Fed. The winding down of its business happened in relative calm. Bear Stearns was involved in numerous derivative positions with many different counterparties. Unwinding these positions could have been chaotic, but it wasn’t, as confidence in the integrity of the system was maintained.
But the way the GSEs were dealt with in September 2008 had significantly negative effects on confidence. Lehman Brothers was also under pressure at the time. Negotiations with the Korea Development Bank to take over Lehman, either alone or as part of a consortium were taking place, but the Koreans suddenly pulled out after shareholders in Fannie and Freddie were wiped out. Other efforts to find a take-over candidate for Lehman failed and Lehman filed for bankruptcy on 15 September 2008. Lehman had a balance sheet total of some USD 600bn, a big bank, but not huge, and it had no retail depositors. According to Bloomberg, the losses of Lehman amounted to USD 75 bn. While this is a large amount, it pales into insignificance compared to the damage done to the world economy resulting from the loss of confidence that followed the Lehman collapse. And this is the key point: the collapse of Lehman triggered a complete and total loss of confidence in the global financial system that led to it seizing up in many countries. Ricardo Caballero talks about a ‘sudden financial arrest’, an analogy with a sudden cardiac arrest in medicine. Soon after, the government decided to rescue AIG. With hindsight, the assets bought by the US government/Fed from Bear Stearns and AIG netted a profit, showing that if given time, positions that look unviable during periods of stress can recover and often do.
Economics and policymaking do not constitute an activity that can be conducted in a sterile lab. It is easy for me to say that US policymakers made big mistakes, causing a complete loss of confidence, turning the bursting of the housing bubble from a significant, unpleasant event into something that threatened to lead to a complete collapse of the global financial system and a depression. It must be said, though, that it is difficult to determine how the crisis would have panned out had decisions been different. We can only make an educated guess.
Europe ‘doing a Lehman’
European financial institutions and investors had bought securities based on the US housing market and had ties with US financial institutions. So Europe was affected by what happened in the US. But Europe also had its own credit bubble. This was (apart from a small number of countries) not so much in housing but in intra-eurozone cross-border lending. In the years after the introduction of the euro, considerable amounts of capital had flown into the ‘periphery’ in search for yield, triggering large deficits on the balance of payments of several countries. When US economic woes led to a global recession, the credit risks in Europe became clear and the financial position of several sovereign borrowers became unsustainable. When the tide went out, all could see who had been swimming naked (to borrow a Warren Buffett phrase). Bail-out packages were required to keep the system functioning, along well-established principles of policy adjustment, official financing and allowing time to adjust and pay back. In 2011, the strategy changed. Until then investors had assumed that sovereign bonds of a eurozone country were (relatively) safe. But in 2011, holders of Greek sovereign bonds were asked to exchange their bonds for new ones with a considerable loss in face value as it became increasingly difficult to explain to the public in other eurozone countries that providing public support to the Greek government was money well spent. And as such, this approach can be understood. An investor should take responsibility when thing do not work out. Having said that, the Greek debt write-down led to significant stress in the financial system in Europe. Spreads of other peripheral countries government bonds widened significantly as holders of these bonds became unwilling to keep them for fear of losses either by defaults, voluntary write-downs or break-up of the euro. The damage done to the eurozone economy was significant.
The business cycle of the European economy has a relatively high correlation with the US business cycle, with Europe usually lagging the US a little. But in the course of 2011 the correlation broke down completely as the US maintained growth in 2011 and 2012 of around 2% on average while the eurozone economy sank into recession in 2011 and has yet to emerge from negative growth. It is unlikely that differences in fiscal policy alone can explain this divergent performance. According to the OECD data on budget deficits, the cyclically adjusted budget deficit in the US declined by 1.1% of GDP in 2011 and by 1.3% in 2012. For the eurozone as a whole the respective numbers were 1.7% and 1.0%. Interestingly, within the eurozone, the cyclically adjusted deficit shrank the most in Germany – 3.2% of GDP over the two years together. Italy and in particular Spain reduced their deficits considerably less: Italy by a total of 2%, Spain only 0.3%. Yet Spain and Italy re-entered recession in 2009, Germany did not. The much more likely explanation for the breakdown in the correlation between the business cycles in the US and the eurozone, and in particular the disappointing performance of the peripheral economies is the stress in the financial system in the eurozone, triggered by the Greek debt problems and especially the Greek debt write-down. The cost of the loss in output and the rise in unemployment was much larger than what it would have cost to prevent the debt write-down. The political choice not to spend taxpayers’ money to bail out investors has ended up costing the tax payers a great deal more, though they are probably unaware of this. It has been particularly costly to tax payers in the periphery who lost their jobs. There are two ways of judging this. On the one hand, it could be described as a significant policy mistake made in an attempt to prevent moral hazard, but primarily because policymakers were unable or unwilling to explain the mechanics of this process to the electorate. Alternatively, one can say that this is the price that has to be paid for restoring market discipline and preventing moral hazard. Take your pick.
Policy mistakes partly driven by neo-liberal ideology
The US government’s decisions to wipe out shareholders in Fannie and Freddie and to let Lehman fail, as well as the decision by eurozone policymakers to force holders of Greek government bonds into a ‘voluntary’ debt write-down have significantly increased stress in the financial system, and have thus made the crisis considerably worse. The question is why these decisions were taken. There are several aspects to this. It can be argued that an extreme neo-liberal view contributed to the disastrous decisions. Hank Paulson’s and a large part of the Republican party’s distrust of the GSEs encouraged them to effectively take control of Fannie and Freddie. And the view that companies must be allowed to fail in order to maintain the capitalist spirit was probably behind the decision to let Lehman go bust. A sad comparison between Paulson and Andrew Mellon, US Treasury Secretary between 1921 and 1932 is hard to avoid. Mellon allowed many banks to fail, which, as mentioned above, was later seen as a huge policy blunder, turning a recession into a depression. Mellon had been a successful banker before taking up his position as Treasury Secretary. Hank Paulson was also a former banker, having been the CEO of Goldman Sachs. The decision in Europe to apply a hair-cut to Greek bonds was mainly driven by public and political outcry against the financial sector. This was certainly not based by an extreme neo-liberal view.
In both cases a failure to recognise the dangers to financial stability and a failure to appreciate the government’s role as provider of confidence of last resort led to decisions that turned out extremely costly. It is a pity that policymakers did not manage to find ways to avoid moral hazard while maintaining financial stability.
Has the free market economy delivered?
Some authors raise the question what economic system produces the best result: the sort of capitalism we had after WWII, characterised by strong government involvement and explicit attempts to perform cycle-stabilising fiscal policy, or the post-Reagan-Thatcher variety with more emphasis on the free market, ultimately leading to the ‘neo-liberal’ version of capitalism. I personally do not believe that a definite answer can be given. Skidelsky compares, among other things, the level of economic growth achieved in both periods. According to the data he uses, the world economy grew at an average rate of 4.8% between 1951 and 1980. From 1989 until 2009 growth amounted to an average of a more modest 3.2%, ‘proving’ the superiority of the Keynesian capitalism over the free-market version. Such comparisons make little sense in my view. One can endlessly argue over the data. Even a mediocre economist can let the data say whatever you want to hear, provided that he is sufficiently creative and perhaps a little manipulative and devious. Skidelsky’s finding has been more or less contradicted by the IMF, which estimates that global growth between 1980 and 2012 amounted to 4.5%. More to the point, particular circumstances matter a lot. It is easier to achieve high growth rates during a catching-up phase than at the frontier of development. With the right policies in place, emerging economies can achieve much higher growth rates than advanced economies. The period of strong growth in the western world after WWII was, in fact, also a phase of catching up. Reconstruction of what had been damaged did not require a lot of innovation, for example. Perhaps it is a little cynical, but even communist countries managed to grow at a decent rate during the initial post-war period.
If one looks at what happens with poverty when lesser developed nations get their act together, it is hard not to conclude that the impact of functioning free markets is huge. According to World Bank data hundreds of millions of people living in countries with improving market economies have been lifted out of poverty since the early 1980s. In ‘East Asia and the Pacific’ the share of the population living in poverty dropped from 77.2% to 14.3% over that period. Progress in South Asia was from 61.1% to 36.0%. The region with the least progress was sub-Saharan Africa: 51.5% in 1981 against 49.2% in 2008. For the world as a whole, people living in poverty has dropped from 43% of the total population in 1990 to 21% in 2010. Perhaps more relevant than the exact version of capitalism for a country’s growth performance is the workings of its institutions as so wonderfully analysed by Acemoglu and Robinson
While global poverty may have declined during the last three decades, income and wealth distribution have become more unequal in many countries, though by no means dramatically so in all western economies. According to The World Top Incomes Database of the Paris School of Economics, the top 1% of earners in the US and the UK earned some 18-20% of total income in 1915. In the UK, this share went down to 5% of total income in 1978 and in the US to some 8%. Following the Reagan-Thatcher revolution the percentages are back up to 14% in the UK and 18% in the US. Some commentators are now pointing to Karl Marx, saying that he got it right all along, that capitalism leads to exploitation and poverty. It seems, indeed, that when left largely to their own devices, markets create unequal outcomes which is acceptable only within a certain range.
The rise of emerging economies and globalisation has contributed to the more unequal distribution of incomes in advanced economies. The lower skilled workers in these economies have been increasingly exposed to unprecedented competition from cheap labour in emerging economies. In addition, several commentators have described the current economic system as a ‘winner-takes-all’ system. There can be several reasons why some markets become ‘winner-takes-all’. Technology is an important factor supporting mega-incomes of superstars in areas such as sports and music. As technology enables a cheap and efficient worldwide distribution of music and of sports viewing, the top talents are able to tap into previously inaccessible markets. One example is the popularity of English football in Asia. Likewise, Barcelona football club increased its total revenue between 2006 and 2012 by 86%, much of that growth coming from outside Spain (according to data by Deloitte). The astronomical incomes of the super stars, be it in sport or music, are often frowned upon, but do not appear to generate such resentment that fans switch off.
Then there are markets where returns to scale do not decrease, but are either constant or increasing. In such markets, a participant who is ahead of the competition will find it not too challenging to stay ahead and shut out competition. This is, arguably, the basis for the sustained success of companies such as Microsoft and Google. As long as they are seen as behaving as reasonably good citizens, their business and incomes are also tolerated. A number of rulings have been made against some of these companies, particularly by the European Commission to open up their products and services. Generally speaking, though, in this neo-liberal era, whether or not companies become too powerful in some areas is only assessed when they take over other companies, if they are in receipt of government support or if there is a suspicion of illegal cartels or abuse of power. Very few people argue for the breaking up these large tech companies. This compares to 1911 when the US Supreme Court ordered the break-up of Standard Oil, which it deemed had become too powerful. Hard to see that happening nowadays other than in the case of a troubled financial institution.
Last, in some other markets, the power structure allows certain participants to extract economic rent for a sustained period. This could perhaps be said to apply to finance. There is little doubt that average incomes in finance are higher than in most, if not all other sectors of the economy, though differences vary greatly between countries. A study by Lawrence Katz found that Harvard graduates working in finance earn three times what their former fellow students with the same grade point average earn in other sectors. Samuelson offers an interesting explanation. He argues that people’s earnings are generally linked to the output value of the organisation they work for. Earnings in finance, he argues, are linked to wealth, because that is what finance deals with. Total wealth in Western economies is much higher than output. People in finance simply play for much higher stakes than workers in most other sectors. This is not a judgment, just an observation. Financial institutions managed to turbo-charge their earnings by building financial leverage into their balance sheets during the neo-liberal era. While differences between earnings within finance are probably larger than elsewhere, the very high incomes were gradually cascaded down in financial institutions. More modest pay packages in finance are required not only from an ethical point of view, they are also an economic necessity given the process of deleveraging in financial institutions.
Why capitalism will change again
My conclusion is that the market economy produces superior results compared to any other system. Despite all the evidence, this is sometimes lost on many on the political left. On the other hand, markets will only give these results if they are functioning properly and embedded in the right framework. Adam Smith knew that, but somehow it is a point lost on many on the political right. Some commentators argue that the rapid growth in China shows that our form of democratic capitalism is inferior to their system and that we need to change to their direction. In response to the Washington Consensus, the ‘Beijing Consensus’ has been developed. The Washington Consensus was seen as dogmatic and rigid. The Beijing Consensus consists of five elements: incremental reform, no big leaps; constant experimentation and innovation; export-led growth; state capitalism; and authoritarian government. Perhaps I am short-sighted, but I find it difficult to believe that countries with democratic rule will voluntarily move to an authoritarian model, though I realise that it has happened before.
I have described above how capitalism has gone through two major transformations in the past: the Keynesian revolution after the depression of the 1930s and the Reagan-Thatcher revolution from 1980 onwards following the stagflation of the 1970s. The reason for these transformations was that the system had become unbalanced, negative sides of capitalism had started to dominate. That is not to say that the particular versions of capitalism had not made their contribution to growth and progress in general. The world economy has benefited greatly from the Reagan-Thatcher revolution with its emphasis on free markets. Over time that system moved into an era of neo-liberalism, which also contributed to growth and progress. But this phase has now come to its end as well. Neo-liberal extremism has led to financial excesses and crisis of a depth that is not acceptable. The system has created inequality that is threatening social cohesion. Too many people feel disillusioned, insecure and threatened by the market. Paradoxically, the size of government is more or less at record levels as a share of the overall economy. Our current mode of capitalism is unlikely in my view to solve today’s problems and provide answers to tomorrow’s challenges.
With hindsight, it was easy to see in what direction capitalism needed to change at the time of the previous two big transformations. The answer to the exploitation of workers was to give them more rights, higher wages and protection by the government. In the 1980s, we needed more emphasis on the market in order to increase growth dynamism. This time around, we appear to need both. This will not be easy and we have reached a very confusing juncture. Huge financial instability has caused a deep economic crisis. Solving this crisis hurts and we are in the middle of the process of distributing the pain.
The political right claims that government sectors are too large and need to be reduced in order to increase economic dynamism. They also claim that an unsustainable number of people in Western societies depend at least for a part of their income on the state and that governments have made promises to the people that they will not be able to keep. Despite thirty years of the Reagan-Thatcher revolution, it is asserted that society has become too soft. The incentive structure has become perverted. The welfare state, meant to be a safety net, has become a ‘lifestyle choice’. People need to be exposed more to the incentives of the market economy, take on more individual responsibility. These are valid points.
The political left argues that the market economy has created an unfair system in which income distribution has become unacceptably skewed. Ordinary people feel increasingly hard done by and insecure in the market economy. They are disengaging. People need to be more protected against the tyranny of the market. The market is there for the people, not the other way around. The political left feel that the crisis has been caused by a small number of people who are largely able to escape unscathed while the common man is bearing the brunt of the pain. Finance has got out of control and needs to be reined in. These are also valid points.
The system that has led us into crisis is unlikely to provide the answers to the significant challenges that lie ahead in the areas of population ageing, health care, environment and climate, water, energy, food safety, etc. What is needed going forward is a redefinition of the roles of the state and of the market and a redefinition of the relationship between state and market. They should not be each other’s enemies, but should complement each other. More than ever before, we need people to realise that a vibrant market economy and effective government are partners.
In my opinion, our system needs to evolve into one of cooperative flexible government intervention in free markets. Governments must recognise their responsibility for overall demand management and financial stability. They must tighten financial regulation but not to the detriment of the financial sector’s ability to support a growing economy. Governments must also get smaller, not larger. They must recalibrate the incentive structure of the welfare system and, at the same time, make sure that people do not feel increasingly alienated. This can only happen if the private sector plays a role as well. Therefore, companies must stop their lopsided focus on shareholder value. They must recognise their social responsibilities as well and they must make a contribution to social inclusion. Government must be realistic about the promises they make to individuals. This is particularly challenging and important in Europe. (Continental) Europe never went as far as the US in adopting neo-liberalism, as it was unwilling to accept all the social dislocations that resulted. Europe seems to have opted for a process of ‘comfortable relative decline’. But that process is unsustainable as it slowly but surely chokes dynamism and the capacity to grow. Where government cannot keep their promises, people must learn to take more responsibility themselves, and in some areas the private sector can perhaps play a role in delivering on the promises made by governments. Companies must fundamentally change their attitude that they ‘know best’ and that government is a costly, good-for-nothing bureaucracy. Companies must increasingly recognise that an active, efficient government is crucial in a market economy. Government must accept that it needs to take responsibility to invest in new areas of advancing technology.
Some of these developments are already underway. Mariana Mazzucato shows how the state has often played a decisive role in the development of crucial innovations. It is simply not true that the market knows best. In many cases, neither the government nor the market ‘knows’, but at least the government can afford to take risks that market participants are unwilling or unable to take.
Developments in the market show that market participants can take responsibility in areas where they have not done so before. Just look at how far we have moved from Milton Friedman’s 1962 view that business cannot bear any social responsibility other than to use its resources and engage in activities designed to increase its profits. Today’s consumers and public opinion demand that companies produce as much as possible in a sustainable, socially responsible way. Many investors weigh social responsibility in their investment decisions. Companies are responding. A focus solely on shareholder value is, indeed, behind us. There is no reason to believe that this process has run its course. In fact, given the challenges ahead and the limitations the public sector is facing, there is only one way forward: that business takes on more and more social responsibilities.
History shows that capitalism rises to the challenges it faces. There is no realistic alternative to capitalism. It is also hard to see democratic countries changing to an undemocratic system and following a model such as China’s. I am convinced that we will move to a new model of capitalism along the lines I have described. In fact, I believe movement is under way. As we are still dealing with the crisis and are facing significant challenges apart from system change, this period will be confusing and may be chaotic. This could be dangerous.
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Global Finance, New Haven and London, Yale University Press, 2009
 The term the Great Moderation was introduced in James Stock and Mark Watson (2002), but was popularised by Ben Bernanke in a speech in February 2004.
 This section draws heavily on Jerry Muller (2008).
 Minsky argued that a period of financial stability lures borrowers into a false sense of security. They then overborrow, which eventually leads to financial instability. Thus, in Minsky’s view, a period of stability will almost certainly ultimately lead to instability.
 The traumatic hyperinflation of the 1920s in Germany is often seen as reason for the big fear among the German public for any policies that could be inflationary. Sometimes one wonders if this hyperinflation trauma can only be overcome if Germany goes through an equally traumatic phase of deflation. I hope not.
 The ten elements of the Washington consensus were the standard measures that the IMF prescribed to countries that had got themselves in trouble: fiscal discipline; cut subsidies; tax reform; positive real interest rates; competitive exchange rates; trade liberalisation; free FDIs, privatisation of state companies; deregulation; protecting property rights.
 Greenspan, 2007, p. 268.
 I am old enough to remember capital controls in Europe. When asked in 2011 in internal meetings in the bank what could happen if Greece were to leave the euro, one of the elements of my answer was that Greece would likely impose capital controls. Most of my younger colleagues stared at me wondering what I was talking about.
 Greenspan, 2007, p. 233.
 This logical argument can sometimes become very emotive. When discussing the crisis at a meeting with ABN AMRO’s executive and supervisory boards in 2011, I said that policymakers had done a good job in stabilising the situation and that that also was their job. The last part of that observation triggered an emotional response from one of the members of the supervisory board who found my attitude insufficiently repentant. Kaletsky phrases it nicely, there still is “unprecedented revulsion against wealth and finance”. (Kaletsky, 2010, p. 272.)
 Kaletsky, 2010, p. 135
 Caballero, 2009
 Experience with Mellon and Paulson suggests that successful bankers do not necessarily make good finance ministers. Recent experience in Holland suggests that it might be easier for a successful finance minister to become a successful bank CEO.
 Skidelsky, 2010, p. 185
 Acemoglu and Robinson, 2012
 According to Forbes, Tiger Woods was the top-earning athlete in 2012, making USD 78m (EUR 60m) in 2012, USD 65m of which through endorsements. Also according to Forbes, Aaron Rodgers, a dropout from the University of California, was the athlete who earned most money directly from his sport, USD 43m (EUR 33m). Rodgers plays American football and my guess is that he is totally unknown outside the US. According to France Football, Lionel Messi, who was only the number nine on Forbes’ list, earned EUR 13m by playing football in the 2012-2013 season and topped his total income up to EUR 35m with other activities. Cristiano Ronaldo was paid EUR 13.5m in salary and bonuses by Real Madrid for a total income of EUR 30m. Top-earning footballer was David Beckham who made EUR 36m, though only 5% of that consisted of income from playing football (Telegraph Sport, 19 March 2013). Just to compare, Lloyd Blankfein, CEO of Goldman Sachs was allegedly paid a total package of USD 54m (EUR 42m) in 2010.
 While writing this part of this paper, I decided to google “why bankers are paid so much?”. When I had typed the first two words, Google tried to help me by suggesting ways for me to finish my query, presumably based on what other people had typed in. The top suggestion was “why bankers are evil”, the third one “why bankers rule the world”. Sadly, this is telling of the times we live in.
 Samuelson, 2010
 A phrase used by UK PM David Cameron in speeches in April 2013
 Mazzucato, 2013