A specter is haunting the world—the return of capitalism. Over the past six months, politicians, businessmen and pundits have been convinced that we are in the midst of a crisis of capitalism that will require a massive transformation and years of pain to fix. Nothing will ever be the same again. "Another ideological god has failed," the dean of financial commentators, Martin Wolf, wrote in the Financial Times. Companies will "fundamentally reset" the way they work, said the CEO of General Electric, Jeffrey Immelt. "Capitalism will be different," said Treasury Secretary Timothy Geithner.
No economic system ever remains unchanged, of course, and certainly not after a deep financial collapse and a broad global recession. But over the past few months, even though we've had an imperfect stimulus package, nationalized no banks and undergone no grand reinvention of capitalism, the sense of panic seems to be easing. Perhaps this is a mirage—or perhaps the measures taken by states around the world, chiefly the U.S. government, have restored normalcy. Every expert has a critique of specific policies, but over time we might see that faced with the decision to underreact or overreact, most governments chose the latter. That choice might produce new problems in due course—a topic for another essay—but it appears to have averted a systemic breakdown.
There is still a long road ahead. There will be many more bankruptcies. Banks will have to slowly earn their way out of their problems or die. Consumers will save more before they start spending again. Mountains of debt will have to be reduced. American capitalism is being rebalanced, reregulated and thus restored. In doing so it will have to face up to long-neglected problems, if this is to lead to a true recovery, not just a brief reprieve.
Many experts are convinced that the situation cannot improve yet because their own sweeping solutions to the problem have not been implemented. Most of us want to see more punishment inflicted, particularly on America's bankers. Deep down we all have a Puritan belief that unless they suffer a good dose of pain, they will not truly repent. In fact, there has been much pain, especially in the financial industry, where tens of thousands of jobs, at all levels, have been lost. But fundamentally, markets are not about morality. They are large, complex systems, and if things get stable enough, they move on.
Consider our track record over the past 20 years, starting with the stock-market crash of 1987, when on Oct. 19 the Dow Jones lost 23 percent, the largest one-day loss in its history. The legendary economist John Kenneth Galbraith wrote that he just hoped that the coming recession wouldn't prove as painful as the Great Depression. It turned out to be a blip on the way to an even bigger, longer boom. Then there was the 1997 East Asian crisis, during the depths of which Paul Krugman wrote in a Fortune cover essay, "Never in the course of economic events—not even in the early years of the Depression—has so large a part of the world economy experienced so devastating a fall from grace." He went on to argue that if Asian countries did not adopt his radical strategy—currency controls—"we could be looking at?.?.?.?the kind of slump that 60 years ago devastated societies, destabilized governments, and eventually led to war." Only one Asian country instituted currency controls, and partial ones at that. All rebounded within two years.
Each crisis convinced observers that it signaled the end of some new, dangerous feature of the economic landscape. But often that novelty accelerated in the years that followed. The 1987 crash was said to be the product of computer trading, which has, of course, expanded dramatically since then. The East Asian crisis was meant to end the happy talk about "emerging markets," which are now at the center of world growth. The collapse of Long-Term Capital Management in 1998—which then–Treasury secretary Robert Rubin described as "the worst financial crisis in 50 years"—was meant to be the end of hedge funds, which then massively expanded. The technology bubble's bursting in 2000 was supposed to put an end to the dreams of oddball Internet startups. Goodbye, Pets.com; hello, Twitter. Now we hear that this crisis is the end of derivatives. Let's see. Robert Shiller, one of the few who predicted this crash almost exactly—and the dotcom bust as well—argues that in fact we need more derivatives to make markets more stable.
A few years from now, strange as it may sound, we might all find that we are hungry for more capitalism, not less. An economic crisis slows growth, and when countries need growth, they turn to markets. After the Mexican and East Asian currency crises—which were far more painful in those countries than the current downturn has been in America—we saw the pace of market-oriented reform speed up. If, in the years ahead, the American consumer remains reluctant to spend, if federal and state governments groan under their debt loads, if government-owned companies remain expensive burdens, then private-sector activity will become the only path to create jobs. The simple truth is that with all its flaws, capitalism remains the most productive economic engine we have yet invented. Like Churchill's line about democracy, it is the worst of all economic systems, except for the others. Its chief vindication today has come halfway across the world, in countries like China and India, which have been able to grow and pull hundreds of millions of people out of poverty by supporting markets and free trade. Last month India held elections during the worst of this crisis. Its powerful left-wing parties campaigned against liberalization and got their worst drubbing at the polls in 40 years.
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.
Government actions should be "countercyclical"—that is, they should work to slow down growth. So, in boom times, the Fed would raise rates and require banks to have higher capital and lower leverage. Fannie Mae and Freddie Mac would start worrying about too much easy credit, raise standards for loans and disqualify buyers unlikely to be able to afford houses. Banks would be urged to slow down the supply of credit cards and other credit instruments. In fact, this is exactly how the governments of China and India behaved in 2007, when their economies were booming. At the peak, consumption in India actually declined as a percentage of GDP.
In the United States, the opposite happened: consumption surged from 67 percent to 73 percent of GDP. Presidents and congressmen extolled the virtues of homeownership for everyone. Congress pushed Fannie Mae and Freddie Mac to extend more loans. Regulators eased up on banks, and the Fed kept rates low. And the public cheered this pandering at every step.
Since Ronald Reagan's presidency, Americans have consumed more than we produced and have made up the difference by borrowing. This is true of individuals but, far more dangerously, of governments at every level. Government debt in America, especially when entitlements and state pension commitments are included, is terrifying. And yet no one has tried seriously to close the gap, which can be done only by (1) raising taxes or (2) cutting expenditures. Any sensible proposal will have to feature both prominently.
This is the disease of modern democracy: the system cannot impose any short-term pain for long-term gain. For 20 years, most serious structural problems—Social Security, health care, immigration—have been kicked down the road. And while the problem is acute in America, Europe and Japan face many of the same difficulties. Right now, the U.S. government's boldness is laudable, but it is being bold in spending money. In a few years, when the bills come due, and Congress must enact major spending cuts as well as raise taxes (and not just on the rich), that's when we will see if things have changed.
In reality, the problem goes well beyond Washington. It also goes beyond bad bankers, lax regulators and pandering politicians. The global financial system has been crashing more frequently over the past 30 years than in any comparable period in history. On the face of it, this suggests that we're screwing up, when in fact what is happening is more complex. The problems that have developed over the past decades are not simply the products of failures. They could as easily be described as the products of success.
Here's why we got to where we are. Since the late 1980s, the world has been moving toward a extraordinary degree of political stability. The end of the Cold War has ushered in a period with no major military competition among the world's great powers—something virtually unprecedented in modern history. It has meant the winding down of most of the proxy and civil wars, insurgencies and guerrilla actions that dotted the Cold War landscape. Even given the bloodshed in places like Iraq, Afghanistan and Somalia, the number of people dying as a result of political violence of any kind has dropped steeply over the past three decades.
Then there is the end of inflation. In the 1970s, dozens of countries suffered hyperinflation, which destroyed the middle class, destabilized societies and led to political upheaval. Since then, central banks have become very good at taming the monster, and by 2007 the number of countries with high inflation had dwindled to a handful. Only one, Zimbabwe, had hyperinflation.
Add to this the information and Internet revolutions, and you have a series of historical changes that have produced a single global system, far more integrated and faster-moving than ever before. The results speak for themselves. Over the past quarter century, the global economy has doubled every 10 years, going from $31 trillion in 1999 to $62 trillion in 2008. Recessions have become tamer than ever before, averaging eight months rather than two years. More than 400 million people across Asia have been lifted out of poverty. Between 2003 and 2007, average income worldwide grew at a faster rate (3.1 percent) than in any previous period in recorded human history. In 2006 and 2007—the peak years of the boom—124 countries around the world grew at 4 percent a year or more, about four times as many as 25 years earlier.
Many of these countries had more cash than they knew what to do with. China sits on a war chest of more than $2 trillion, while eight other emerging-market nations have reserves of more than $100 billion. They've all looked to the safest investment they could imagine—U.S. government debt. In buying so much debt, they drove down the interest rate Washington had to offer, which in turn made credit in America cheap. So the effect of all this money sloshing around the world was to subsidize Americans in their favorite activity: shopping. But it affected other Western countries as well, from Spain to Ireland, where consumers and governments loaded themselves up with debt.
Good times always make people complacent. As the cost of capital sank over the past few years, people became increasingly foolish. The world economy had become the equivalent of a race car—faster and more complex than any vehicle anyone had ever seen. But it turned out that no one had driven a car like this before, and no one really knew how. So it crashed.
The real problem is that we're still driving this car. The global economy remains highly complex, interconnected and im-balanced. The Chinese still pile up surpluses and need to put them somewhere. Washington and Beijing will have to work hard to slowly stabilize their mutual dependence so that the system is not being set up for another crash.
More broadly, the fundamental crisis we face is of globalization itself. We have globalized the economies of nations. Trade, travel and tourism are bringing people together. Technology has created worldwide supply chains, companies and customers. But our politics remains resolutely national. This tension is at the heart of the many crashes of this era—a mismatch between interconnected economies that are producing global problems but no matching political process that can effect global solutions. Without better international coordination, there will be more crashes, and eventually there may be a retreat from globalization toward the safety—and slow growth—of protected national economies.
Throughout this essay, I have avoided treating this economic crisis as a grand morality play—a war between good and evil in which demon bankers destroyed all that is good and true about our socie-ties. Complex historical events can rarely be reduced to something so simple. But we are suffering from a moral crisis, too, one that may lie at the heart of our problems.
Most of what happened over the past decade across the world was legal. Bankers did what they were allowed to do under the law. Politicians did what they thought the system asked of them. Bureaucrats were not exchanging cash for favors. But very few people acted responsibly, honorably or nobly (the very word sounds odd today). This might sound like a small point, but it is not. No system—capitalism, socialism, whatever—can work without a sense of ethics and values at its core. No matter what reforms we put in place, without common sense, judgment and an ethical standard, they will prove inadequate. We will never know where the next bubble will form, what the next innovations will look like and where excesses will build up. But we can ask that people steer themselves and their institutions with a greater reliance on a moral compass.
One of the great shifts taking place in American society has been away from the old guild system of self-regulation. Once upon a time, law, medicine and accounting viewed themselves as private-sector participants with public responsibilities. Lawyers are still called "officers of the court." And historically they acted with that sense of stewardship in mind, thinking of what was appropriate for the whole system and not simply for their firm. That meant advising their clients against time-consuming litigation or mindless mergers. Elihu Root, a leader of the New York bar in the late 19th century, once said, "About half the practice of a decent lawyer consists in telling would-be clients that they are damned fools and should stop."
It's not just the law that has changed; so have all the professions. Ever since the 1930s, accountants have been given a unique trust. "Who audits you?" asked Sen. Alben Barkley during a 1933 committee hearing. "Our conscience," replied Arthur Carter, the head of a large accounting firm. But by 2002 The Wall Street Journal was describing a different world, in which accountants had gone from "watchdogs to lapdogs," telling clients whatever they wanted to hear. Bankers similarly once saw themselves as being stewards of capital, responsible to their many constituents and embodying trust. But over the past few decades, they too became obsessed with profits and the short term, uncertain about their own future and that of their company. The most recent example of this phenomenon has been at the rating agencies, which were generating fees that were too lucrative to be exacting in their judgments about their clients' products.
None of this has happened because businesspeople have suddenly become more immoral. It is part of the opening up and growing competitiveness of the business world. Many of the old banks and law firms operated as monopolies or cartels. They could afford to take the long view. They were also run by a WASP elite secure in its privilege. The members of today's meritocratic elite are more anxious and insecure. They know that they are being judged quarter by quarter.
The failure of self-regulation over the past 20 years—in investment banking, accounting, rating agencies—has led inevitably to the rise of greater government regulation. This marks an important change in the Anglo-American world, away from informal rules often enforced by private actors toward the more formal bureaucratic system common in continental Europe. Perhaps the state should not set the pay of the private sector. But surely CEOs should exercise some judgment about their own compensation, and tie it far more closely to the long-term health of the company. It will still be possible to get very rich—Warren Buffett, after all, draws a salary of only $100,000.
There's a need for greater self-regulation not simply on Wall Street but also on Pennsylvania Avenue. We get exercised about the immorality of politicians when they're caught in sex scandals. Meanwhile they triple the national debt, enrich their lobbyist friends and write tax loopholes for specific corporations—all perfectly legal—and we regard this as normal. The revolving door between Washington government offices and lobbying firms is so lucrative and so established that anyone pointing out that it is—at base—institutionalized corruption is seen as baying at the moon. Not everything is written down, and not everything that is legally permissible is ethical. Who was the last ex-president to refuse to take a vast donation for his library from a foreign government that he had helped when in office?
We are in the midst of a vast crisis, and there is enough blame to go around and many fixes to make, from the international system to national governments to private firms. But at heart, there needs to be a deeper fix within all of us, a simple gut check. If it doesn't feel right, we shouldn't be doing it. That's not going to restore growth or mend globalization or save capitalism, but it might be a small start to sanity.