Capitalism means growth, but also instability.
The system is dynamic and inherently prone to crashes that cause great damage along the way. For about 90 years, we have been trying to regulate the system to stabilize it while still preserving its energy. We are at the start of another set of these efforts. In undertaking them, it is important to keep in mind what exactly went wrong. What we are experiencing is not a crisis of capitalism. It is a crisis of finance, of democracy, of globalization and ultimately of ethics.
"Capitalism messed up," the British tycoon Martin Sorrell wrote recently, "or, to be more precise, capitalists did." Actually, that's not true. Finance screwed up, or to be more precise, financiers did. In June 2007, when the financial crisis began, Coca-Cola, PepsiCo, IBM, Nike, Wal-Mart and Microsoft were all running their companies with strong balance sheets and sensible business models. Major American corporations were highly profitable, and they were spending prudently, holding on to cash to build a cushion for a downturn. For that reason, many of them have been able to weather the storm remarkably well. Finance and anything finance-related—like real estate—is another story.
Finance has a history of messing up, from the Dutch tulip bubble in 1637 to now. The proximate causes of these busts have been varied, but follow a strikingly similar path. In calm times, political stability, economic growth and technological innovation all encourage an atmosphere of easy money and new forms of credit. Cheap credit causes greed, miscalculation and eventually ruin. President Martin Van Buren described the economic crisis of 1837 in Britain and America thusly: "Two nations, the most commercial in the world, enjoying but recently the highest degree of apparent prosperity and maintaining with each other the closest relations, are suddenly?.?.?.?plunged into a state of embarrassment and distress. In both countries we have witnessed the same [expansion] of paper money and other facilities of credit; the same spirit of speculation?.?.?.?the same overwhelming catastrophe." Obama could put that on his teleprompter today.
Many of the regulatory reforms that people in government are talking about now seem sensible and smart. Banks that are too large to fail should also be too large be leveraged at 30 to 1. The incentives for executives within banks are skewed toward reckless risk-taking with other people's money. ("Heads they win, tails they break even," is how Barney Frank describes the current setup.) Derivatives need to be better controlled. To call banks casinos, as is often done, is actually unfair to casinos, which are required to hold certain levels of capital because they must be able to cash in a customer's chips. Banks have not been required to do that for their key derivatives contract, credit default swaps.
Yet at the same time, we should proceed cautiously on massive new regulations. Many rules put in place in the 1930s still look smart; the problem is that over the past 15 years they were dismantled, or conscious decisions were made not to update them. Keep in mind that the one advanced industrial country where the banking system has weathered the storm superbly is Canada, which just kept the old rules in place, requiring banks to hold higher amounts of capital to offset their liabilities and to maintain lower levels of leverage. A few simple safeguards, and the whole system survived a massive storm.
The simplest safeguard American regulators have had, of course, is the interest rate on credit. In responding to almost every crisis in the past 15 years, former Fed chairman Alan Greenspan always had the same solution: cut rates and ease up on money. In 1998, when Long-Term Capital Management collapsed, he suddenly and dramatically slashed rates, even though the economy was roaring along at 6 percent growth. In late 1999, buying into fears about Y2K, he swamped the markets with liquidity. (One effect: between November 1998 and February 2000, when rates finally rose, the NASDAQ jumped almost 250 percent, increasing in value by more than $3 trillion.) And finally, when the technology bubble burst and 9/11 hit, Greenspan again lowered rates and kept them low, this time inflating a massive housing bubble.
Greenspan behaved like most American political leaders over the past two decades—he chose the easy way out of a hard situation. William McChesney Martin, the great Fed chairman of the 1950s and 1960s, once said that his job was to take the punch bowl away just as the party had begun. No one wants to do that in America anymore—not the Fed chairman, not the regulators, not Congress and not the president.