This has not been a pure failure of markets

By Leszek Balcerowicz

Only the rulers of Cuba, Venezuela, Iran and some ideologues in the west condemn capitalism. Empirically minded people know that there is no good alternative. However, capitalism takes many forms and evolves over time. The questions to ask, then, are “What capitalism?” and “Does the present crisis shed new light on this issue?”

The popular condemnations of “greed” in response to the crisis seem to me superficial. Economists are expected to explain human behaviour in terms of situational factors and not to compete with preachers and politicians. Equally unconvincing is the speculation about what John Maynard Keynes would be saying were he alive.

As a preliminary step to a more productive analysis, let us recall that not long ago Japan Inc, the Rhineland model and other statist or corporatist varieties of capitalism were praised as a better alternative to the more market-oriented Anglo-Saxon variant of this system. Since then, based on solid empirical research, there has been a wave of deregulation of the product and labour markets, and the European Union has set itself the ambitious goals of the Lisbon Agenda.

Faced with high structural unemployment, fiscal pressures and ageing societies, many western economies have started to reform their over-extended welfare states. China and India have accelerated their growth thanks to a reduction in the political control of their economies. Central and eastern European countries show that the more market reforms you accumulate, the faster is your longer-term growth. These and other initiatives have reduced the crippling statist bias and extended the role of markets and civil society. The present crisis means we must take further measures to release entrepreneurial capitalism, offsetting declines in gross domestic product caused by the financial crisis and the legacy of attempts to manage it, especially the hugely increased public debt.

But is the financial sector an exception? Can the crisis be interpreted as a pure market failure, which requires more public intervention? It is easy to agree on the facts – increased leverage and asset bubbles in many economies, as well as serious errors made at the top of huge financial conglomerates. Symptoms, however, should not be confused with causes, and it is with respect to the causes that there is serious disagreement.

The argument that we have witnessed a pure market failure fails the most elementary tests. Financial institutions and markets operate within the macroeconomic, regulatory and political framework created and maintained by public bodies, and it is empirically not difficult to point to the serious deficiencies of this framework that contributed to the present crisis.

There is scope for further analysis of the relative contributions of the US Federal Reserve’s easy monetary policy in the early 2000s and the “savings glut” in some emerging economies. With a more restrictive Fed policy (and with more disciplined fiscal policy under George W. Bush, the former US president), there would have been initially slower growth but less increase in the savings glut later, a smaller build-up of financial imbalances and, as a result, less disruption to growth.

Excess liquidity encouraged the spread of powerful short-term incentives in the financial institutions. Fannie Mae and Freddie Mac were largely the tools of political intervention in the US housing market. Some financial regulations might have accelerated the spread of the originate-to-distribute model, which is blamed for amplifying leverage and obscured the allocation of risks. Those EU economies that developed the most extreme housing bubbles – Britain, Ireland, Spain – stimulated demand for housing with tax breaks.

Analytically based lessons from the present crisis should focus on revisions of the macroeconomic and regulatory frameworks for financial markets that would reduce the risks of dangerous booms and the resulting busts. Policies that contribute to the emergence and growth of huge financial conglomerates – which, once in crisis, endanger the financial stability of whole countries – should be identified and eliminated.

These proposals have nothing to do with grandiose schemes for reinventing market capitalism. However, every crisis produces a shock to mass beliefs and thus may have policy consequences. In a democracy, the impact of economic crises is mediated by competing interpretations provided by intellectuals and politicians, and conveyed by the media. There is a risk that empirically dubious but emotionally attractive interpretations, which condemn markets and call for more statism, could gain ground. This would damage longer-term growth in the affected countries and could have serious geopolitical consequences if major western economies, especially the US, already burdened by the legacy of the crisis, were to succumb while China continued its reforms.

Mises, Hayek, Schumpeter, Nozick and other thinkers have noted that under democratic capitalism there are always influential intellectuals who condemn capitalism and call for the state to restrain the markets. Such an activity bears no risk and may be very rewarding. (This contrasts strongly with the consequences of criticising socialism while living under socialism.)

Dynamic, entrepreneurial capitalism has nowadays no serious external enemies; it can only be weakened from within. This should be regarded as a call to action – for those who believe that individuals’ prosperity and dignity are best ensured under limited government.

The writer, a former Polish deputy prime minister and governor of the National Bank of Poland, is a professor at the Warsaw School of Economics.

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