Final Thoughts

Over the last number of weeks I have examined the link between capitalism and financial crises.  In week one I examined the origins of capitalism, and highlighted the powerful growth mechanism it seems to provide.  I also suggested that what just happened in the recent financial crisis was merely another blip in what Minsky described as a crisis-prone system. 

In week 2, I then focused on why capitalism may be prone to crises.  I began by investigating the ideas of Karl Marx, and found that whilst many of his arguments have been discredited, his suggestion that capitalism is inherently unstable has considerable consistency with reality.  Extending on this, I examined the creative destruction rationale of Schumpeter, who suggested that crises provided the necessary destruction to catalyze innovation and growth.  Furthermore, I also discussed animal spirits and irrational exuberance which gave rise to the boom-bust cyclical pattern observed in capitalism, and so highlighted why this creative destruction was inherently necessary.  Additionally, I identified how the capitalist waves may be exacerbated by the cushion of limited liability. 

Last week, I then examined the association between capitalism and various crises throughout history.  Ultimately, I found that crises have considerable consistency, and tended to result as a product of financial innovation, credit quality and government regulation reasons.  I also suggested that in early crises, a broad lack of financial sophistication may have led to periods of irrational exuberance which ultimately led to bubble formation.  However, I suggested that in later crises financial institutions and investors may have rationally engaged in the bubble to generate profits, perhaps due to a lender of last resort (moral hazard problem).

Finally, this week I examined the future of capitalism and suggested that it will probably survive the latest crisis.  However, in a society with greater economic and informational freedom I postulated that this may lead to a more responsible capitalism with greater regulation and accountability.  Yet, capitalism will probably always be crisis prone, and will most likely self-destruct when we least expect !  I finish with a quote from P.J. O’Rourke who summarizes the implications of capitalism concisely,

“The idea of capitalism is not just success but also the failure that allows success to happen”

The Future

The recent financial crisis has reignited the debate about whether capitalism is sustainable and equitable in its current form.  In the following video Robert Peston explores these issues, and considers the future of our capitalist society.  (This is followed by a short summary and discussion.)

The video effectively articulates how the tax-payer has been held to ransom through financial sector failure.  It also demonstrates how this crisis was exacerbated by a bonus bonanza culture which is far removed from the many frugal individuals who now foot the bill.  Of course, today, we are all too aware of the stigma bankers face from a society which resents the long term hardship they have been forced into, as a result of banker decadence and greed.  And so, it seems reasonable to assert that the power of the crowd will elicit a new deal for capitalism, whilst recognising the importance of the financial sector in generating UK economic growth. 

So what will this new capitalism look like?  As Peston suggests, it is likely greater regulation will result in an attempt to create a more stable, ethical and responsible capitalism.  However, given the power of crony capitalism and our bureaucratic political system, is there any reason to think that capitalism will truly change?  I believe so for two related reasons: the power of democracy and the power of media. 

In short, governments under a democratic mandate are now held to greater ransom by the transparency and accountability generated by the media.  This has been evident through the recent government expenses scandal and is manifested continually though informational freedom via the internet, television and other media forms.  Hence, this should encourage government to constrain the destructive power of capitalism and place greater emphasis on well-being rather than wealth.

However, the recent crisis underlined the greatest danger with capitalism – complacency.  For example, The Great Depression was followed by a period of social accountability and regulation which weakened with the passage of time as we became increasingly nestled in fall sense of security.  Then ..............BANG!!!!              

Time Out

This week I have carried out a broad analysis of the role of capitalism in financial crises throughout history, focusing on crises from the Tulip Mania in the 17^th century to the recent 21^st century crash.  In early crises, capitalism seemed to liberate animal spirits and give rise to speculative bubbles as investors clambered to capitalize on the waves generated by market liberalization.  Yet recent crises, such as the Asian crisis or the 2008 crisis, also suffered from bubbles suggesting that sophisticated investors may profiteer by ‘riding the wave’ at the expense of society more broadly.  Furthermore, many of the crises have also been prolonged or exacerbated through government failure, in particular the Great Depression, Asian Crisis and recent crisis.  This suggests that government should be cautious about deregulation, given the phony financial behavior it tends to generate in a greater grab for profits.  It also highlights the conflicts of interest policy makers may face, and the potential for crony capitalism.

Next week, as mentioned in my last post, I will focus on the future of capitalism in its current form.  As it is the last week of my blog, I will also give an overview of my findings and examine their implications.  

Recent Crisis - Repair or Write Off?

The recent financial crisis, like many of its predecessors, has been met with an assertion that “this time is different” (Reinhart and Rogoff, 2008).  Yet, Reinhart and Rogoff suggest that factors such as interest rate shocks and commodity price collapses have been common in financial crises throughout the last 8 centuries.  With this in mind, they suggest the 2008 “US sub-prime financial crisis is hardly unique”.  Moreover, Demirgüç-Kunt and Detragiache (1998) argue that financial liberalization and subsequent innovation have been important factors in financial crises throughout history, and Mishkin (2009) proposes that mismanagement of this resulting innovation is of particular significance. 

In the US, deregulation of the financial markets, and low interest rates gave rise to a housing bubble which would act as a catalyst for the 2008 crisis.  More specifically, securitization fostered a culture of lax credit control to meet the demands of a liquid market, and so the housing bubble grew.  Interestingly, Alan Greenspan, former Chairman of the Federal Reserve (1987-2006), and a keen advocate for capitalist free markets, commented in 2008, “the immense and largely unregulated business of spreading financial risk widely, through the use of exotic financial instruments called derivatives, had gotten out of control.”  (Full article here)

The magnitude and severity of the recent crisis cannot have gone unnoticed by even the most vehement supporters of capitalism.  In particular, the ‘violent’ nature of this creative destruction emphasizes the social costs such a system can generate, especially to the most deprived in society.  For example, it could be argued that financial innovation enabled the less well-off to ‘afford’ housing through lax credit requirements, but then entrenched many of these same people in a life of debt, whilst sophisticated banking institutions and investors profiteered from the speculative bubble, cushioned by limited liability and a lender of last resort.   However, we should also remember that whilst capitalism does not generate an earthly utopia, it has provided a powerful and unparalleled growth mechanism.

So what’s the future for capitalism, and have we learned anything from the recent financial Armageddon?  BBC business editor Robert Peston has examined this issue in two special reports for BBC News.  I will focus more on answering these questions next week, but I will post the first video here as it summarizes the recent financial crisis and provides a sneak peak of what’s to come!

Orient Excess

In 1997 a financial crisis struck the so called Asian tigers – Hong Kong, Philippines, Singapore, South Korea etc.  The following video provides a short insight into how the crisis unfolded and highlights a number of important factors.

Notably, like both the Florida housing bubble which preceded the Great Depression and the wider housing bubble which preceded the 2008 crisis, a property boom (1995-1997) paved the way for the Asian crisis.  Furthermore, this was facilitated by increased money supply which encouraged individuals to take on more debt, and ultimately this liquidity glut fueled the housing bubble. 

Radelet and Sachs (2000) suggest that the crisis was characterized by government policy errors, international panic and the lack of an international rescue program.  Furthermore, Rajan and Zingales (1998) also suggest that the relationship-based system (more information here) led to an accumulation of short term capital inflows which are prone to panic and bubble formation.  Interestingly, this relationship-based capitalism led to the emergence of a bubble in a system with poor transparency, similar to the derivatives story of the 2008 crisis.  Additionally, government failure is common in both the Asian crisis and the 2008 crisis (e.g. actions of ECB).

Despite the 1997 crisis, capitalism continues to flourish in Asia.  An interesting FT article (full article here) suggests that whilst the 1997 crisis was a blow to capitalism, memories of Indian Nehruvian socialism or the Maoist centrally planned economy quickly erode any misgivings of the capitalist system.  However, the Asian crisis also brings to the fore another pertinent issue – crony capitalism (Kang, 2002).  

Crash and Burn?

The Great Depression was the most pronounced recession of the 20^th century and followed the Wall Street Crash of 1929.  Former US President Calvin Coolidge described the onset of the depression in 1932, “In other periods of depression, it has always been possible to see some things which were solid and upon which you could base hope, but as I look about, I now see nothing to give ground to hope – nothing of man.”  The following video gives a short insight into the Great Depression and highlights its global reach. 

This Great Depression has a strong resonance with the current economic depression.  For example, Eichengreen and Mitchener (2003) identify the following features of the Wall Street Crash and subsequent Great Depression which seem broadly similar with the 2008 crisis: “cheap credit, a property boom, increasing consumer debt, and rising equity prices.”  Furthermore, David Murphy (2009) in his book, “Unravelling the Credit Crunch” highlights 3 areas of improper behavior identified by the Senate Banking and Currency Committee in 1934 which could readily apply today; crony capitalism (e.g. insider trading), fraud and antisocial behavior (e.g. tax avoidance). 

The Wall Street Crash and Great Depression also led to the infamous Glass-Steagall Act which attempted to curb such behaviors.  Interestingly, this legislation seemed to keep capitalism on the ‘straight and narrow’ until is repulsion in the 1990’s (more information here) ushered in a new age of financial innovation, and paved the way for the emergence of a housing bubble and subsequent financial crisis.  It should also be noted that the banking system became more deregulated through the 1920’s e.g. McFadden Act (1927), similar to the greater deregulation which occurred before the current crisis. 

There are two distinct views about how the why the Great Depression became so ‘great’.  The first is the monetarist view of Friedman and Schwartz (1963).  They suggest the Fed exacerbated the crisis through its unwillingness to act as a lender of last resort which spread panic, and further, by failing to increase money supply (perhaps due to fear of a new bubble).  In contrast, Bernanke (1983) argues that although money supply fell, it cannot entirely account for the output erosion.  Instead, Bernanke advocates that the banking crisis led to a break-down of credit provision to the economy.

South Sea Bubble

Roll on almost 100 years and another interesting case is that of the British “South Sea Company”.  In 1711, the company signed a contract with the British government which gave them a trading monopoly with South American colonies in return for financing government debt.  The lure of the potential ‘South Sea treasure chest’ and the success of the John Law’s “Mississippi Company” in France (another speculative venture) ignited a speculative mania for the company’s stock, facilitated by a grandiose image and management corruption.  (Other fraudulent companies also emerged to capitalize on the benefits of investor exuberance).  However, as share prices soared, management realized the gross-overvaluation which had occurred, and sold their stock leading to investor panic and rapid downward price pressure.  Shares became almost worthless, and eventually the Bank of England intervened as a lender of last resort to avoid a wider financial crisis.   

South Sea Bubble (1720)

Dale et al. (2005) empirically examine the bubble and argue that it closely conforms to the Neal’s (1990) definition of an irrational bubble: “the relationship of an asset to its market fundamentals simply breaks down because of overzealous trading or an unrealistic appraisal of the value of the stock.”  Notably Dale et al. point out that many investors were new to capital markets, suggesting that there existed an irrational optimism for financial instruments which they did not fully understand, which sounds similar to the actions of investors on the derivative markets in the 2008 crisis. 

Additionally, Neal and Weidenmier (2003) suggest that the Bank of England under political pressure became a reluctant lender of last resort in 1723 to the South Sea Company.  Furthermore, they describe 1723 as the “big-bang for financial capitalism” as it provided a “complementary set of private commercial and merchant banks all enjoying continuous access to an active, liquid secondary market for financial assets, especially government debt”.  However, it also suggests that this safety net may have catalyzed the boom-bust pattern we observe in modern capitalism.  Interestingly, Wilson (1940) suggests that the modern business cycle can be traced to the 1760’s, soon after the South Sea debacle.  

Flower Power!

Fueled by speculative competition for futures contracts, Tulip Mania gripped the Netherlands in 1630’s leading to mind-boggling price levels.  Mackay (1841) puts this in context by stating that in 1635 forty bulbs fetched 100,000 florins, compared with just 100 florins for 1 ton of butter!  Interestingly, Roubini and Mihm (2011) in their book "Crisis Economics" emphasize the timeliness this asset bubble had with “the emergence of the Netherlands as the world’s first capitalist dynamo in the sixteenth and seventeenth centuries”, and so point to the roots of financial speculation in the emergence of free-market capitalism.  Notably, Garber (1989) (a prominent commentator on the subject) suggests that this should not be considered as a case of irrational exuberance, as flower bulbs are prone to such pricing behavior.  The figure below demonstrates this ‘Tulip Mania’ graphically.  

Tulip Mania (1636-1637)

Half Time

In the first week of this blog I began by examining the origins of capitalism, and how it may give rise to financial crises, concentrating on the ideas of Hyman Minsky.  I also demonstrated how a capitalist system may emerge by focusing on the attractive growth mechanism it seemed to provide, as well as being an alternative during socio-economic distress.  

This week I have focused on why capitalism may be vulnerable to financial crises.  Firstly, I examined the propositions of Karl Marx, a vehement opponent of capitalism, who argued that such a system led to an elitist power vacuum.  This system, he suggested, would inevitably meet a violent end through a worker uprising facilitated by its monopolistic tendencies.  Whilst many of Marx’s ideas have little academic support, his recognition of the inherent instability of capitalism is important.  Attention was then directed to Schumpeter’s creative destruction characterization of capitalism.  In short, Schumpeter was an advocate for the dynamism of capitalism, and suggested that destruction led to a revitalized system which was necessary for economic growth.  I also illustrated how animal spirits and irrational exuberance could lead to the emergence of speculative bubbles, and identified how the safety net of limited liability may act as a catalyst for this seemingly irrational risky behavior. 

Next week, I will focus on whether capitalism has been associated with specific financial crises throughout history.  

"Casino Capitalism" and Limited Liability

Hans-Werner Sinn (2010) in his book “Casino Capitalism” argues that it is not irrational exuberance which causes capitalist crises but instead limited liability.  In fact, Sinn suggests that speculative investors exhibit rational behavior because, unlike gamblers who face a negative expected mathematical payoff, they have they promise “of huge private profits at the expense of society” leading to a payoff “above the stakes”.  

Sinn suggests that commercial limited liability flourished in medieval Italy in an arrangement referred to as “commenda”, driving economic advancement in cities such as Florence, Venice and Pisa.  Today, he suggests the high standard of living observed in the ‘West’ is a product of capitalism which “goes hand in hand with the corporation and limited liability”.  Sinn goes on to propose that this incentivises investment banks to become under-capitalized and engage in high risk behavior.  However, he also suggests that stockholders are the main source the problem as they are only interested in profits, and given the cushion of limited liability they encourage riskier behavior by banks.  Sinn suggests that this leads to the manifestation of Akerlof’s (1970) lemon problem – lower risk investment banks, unable to explain their safer position to customers, disappear as they cannot compete with the higher return offered by their higher risk counterparts.  

This limited liability proposition is particularly powerful as it provides a framework to explain the apparent irrational exuberance we observe in capitalist systems.  In essence, it identifies a lack of accountability as a product of limited liability which could potentially fuel a culture of crises.