Is capitalism to blame for today’s problems?

Introduction

These days it is hard to not come across an article lamenting capitalism in connection with today’s problems. The credit crisis of 2007-2008 has been used by many as an example of unbridled capitalism and its destructive nature. As a lot of the problems have originated from the financial sector, it cannot come as a surprise that people make such claims. However, the notion that capitalism is the cause of the aforementioned crisis is not just incorrect, it is exactly the opposite; capitalism would have prevented such a crisis from forming in the first place. Due to this misdiagnosis, policy measures were taken so far not only negatively affect the economy, but also democracy at large. By curtailing economic freedom, policy makers are curtailing personal freedom itself, thus affecting the trajectory of democratic development.

Capitalism as a scapegoat

Concerning the causes of the 2007-2008 credit crisis, experts seem to focus on three characteristics they, apparently, link to capitalism. A combination of inadequate regulation, greed, and credit expansion, were to blame for the crisis that shook the world to its core eight years ago and it still being felt today.

Lack of regulation

Due to inadequate regulation, the financial sector took on too much risk. Banks, insurance companies, investment firms and so forth, could engage in all kinds of financial engineering, making things look better that they really were. As there was a lack of regulation, the products resulting from this financial engineering (CDO, MBS, CDS and so forth) were misrepresented and mispriced. As long as all went well, the sector reaped huge financial gains from taking these (hidden) risks, but when things started to get dire, the potential losses were of such magnitude that they posed a risk to the entire economy. Hence, the government had no choice but to provide a bailout. In a sense, profits were made private while losses were made public. According to most experts, this is proof that capitalism is inherently unfair and needs to be regulated so as to fairly distribute the risks, costs, and benefits associated with it.

Greed

Capitalism is often used as a synonym for greed. According to some observers, it is all about self-interest and short-termism. As everyone is pursuing their own self-interest, the system is bound to offer subpar results at best, and detrimental ones at worst. In this context, the word “bonus” has a totally different connotation than it did twenty years ago. Now it is seen as one of the primary causes of excessive risk-taking and short-termism within finance firms. For example, a trader with a bad year to date performance in September is stimulated by the bonus system to go all out in the last quarter; if it does not work, then he will lose his job, which is the same situation he was in back in September anyway. If his trades succeed however, he saves the day, his job is safe and he gets a bonus. It is clear that this bonus set up, typical of capitalism, stimulates the wrong kind of behaviour and this is the reason that regulatory agencies are eyeing to regulate bonuses (and thus capitalism) as well.

Credit expansion

One cannot get a credit crisis without excessive credit, and as many experts claim that the capitalist system promotes credit creation, causation is a given. The greed factor discussed above is one of the drivers they often mention and it is easy to see why. Another one is that financial engineering can obscure the true riskiness of a company. As a healthier company can demand lower interest rates on its loans, it can also take on more debt than it actually should. The loan is then used to make investments, which fuels demand for certain goods and services. This, in turn, has second-hand effects of increasing investments in the supply chain of this company, and so forth. This multiplier effect increases business activity and increases the demand for credit, but it was started by a company that did not warrant getting as much credit as it did. In the end, the company in question might indeed have over borrowed and ends up in default. Then the entire supply chain takes a hit as demand disappears. As they have invested in extra capacity, the pain is more pungent. The self-correcting mechanism that capitalists claim works, does not, or works too late to prevent unnecessary harm according to certain experts. The 2008 crisis is, in their opinion, a perfect example of this, as a number of debts broke record after record, without even so much as a worry, let alone a correction.

Reality check

Just from a macro point of view, it is strange that experts claim capitalism is at fault, as it is clearly not practiced. Looking at the Eurozone, the government is responsible for about half of GDP. This runs totally against the capitalist principle of having a small government in charge of just Defence and Justice. Looking at the minimum wage, petrol subsidies and taxes, different VAT levels and the like, one can hardly claim that the prices that consumers and businesses face are true market prices (i.e. set by the market).

Lack of rules?

The three causes of the credit crisis offered by many specialists are also wrongly blamed on capitalism. If someone wants to chop a tree in their garden or their kids want to sell lemonade on the curb, they need to get a permit first. This is anecdotal, but if one cares to take a look at the financial sector, it is possibly the most heavily regulated sector of the economy. Looking closer, one comes to the conclusion that regulations in the run up to 2008 were one of the causes of the credit crisis! For example, due to bank regulation, a loan to the Greek government (or that of France, Italy, Spain, Portugal, Ireland, et cetera) was termed riskless, while a loan to Unilever was termed risky (in 2008, half of the loan sum could be at risk of default according to regulators so banks needed to set aside 4% over that part of the loan, which was costly). This regulation thus created artificially cheap credit to these countries which later took centre stage in the 2008 crisis, while Unilever had no real problems whatsoever. Regulation also is, in part, responsible for too much credit creation by enforcing a mispricing of risk, leading to the aforementioned cheap loans, which in turn lead to more demand for them (the lower the price, the higher the demand). These are just a few of many examples of regulation actually causing major market (pricing/supply) distortions (just look at the asset management regulations).

Credit boosters

Furthermore, a lot of financial engineering can be directly linked to regulations, as these new innovative finance products helped companies meet new regulations. As there was an overemphasis on risk, many companies resorted to using these financial products to dress up their balance sheets. Risk is an essential ingredient of capitalism. An investor’s choice is to invest his capital into something which carries risk. The question for him is to determine if the potential gains outweigh the risks. Risk perception, determines price and thus capital allocation. Regulation distorted this mechanism by changing the risk perception. Also, if an investment turns sour, the investor should bear all the consequences, not the public. But by bailing out companies and banks, governments have essentially blocked capitalism’s clean up system for doing its job; getting rid of malfunctioning companies. This, in turn, has led to what is called moral hazard, as certain (mainly financial) companies knew they would be bailed out if their bet went the wrong way. This is definitely not capitalism and more akin to cronyism.

A capitalist system will also give the capital providers a say in the company (voting power) and, depending on the country, a supervisory board of sorts has the job to supervise management. Taking on too much risk, handing out exorbitant salaries or having the wrong kind of incentive schemes is exactly what they are supposed to prevent from happening. In reality, shareholders are often curtailed in their voting power (timing, for example), while the supervisory board is too interlinked with the people running the company. This is again more akin to cronyism than to capitalism. Increasing the voting power of shareholders (capitalists) and making the supervisory board liable for any neglect of duty, would come a long way to solving these deficiencies. This means more capitalism, instead of less.

Freedom

A hidden theme in the contra capitalist camp is more centralization of power, preferably at the government level. Governments should determine what is risky, what the price of something should be and what is right or wrong for you and me. In this sense, it is reducing the freedom of the individual. The capitalist camp, on the other hand, basically promotes decentralization; individuals should be left alone to invest, save, consume and so forth as they see best. They should reap the benefits of their decisions, but also the drawbacks (no bailouts). Capitalism is essentially a manifestation of human nature, and deviating from it creates a less natural, less human and certainly a less free society. It is for this reason that capitalism and the most decentralized form of democracy, a direct democracy, go together so well. Preventing true capitalism from taking place in favour of a centralized approach to the economy is not only reducing individual freedom but also blocking democratic evolution. Instead of progressing toward a direct democracy, Europe seems to regress toward a centralized and autocratic system. Instead of attacking capitalism, we should demand more of it.