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THE CURRENT CRISIS AND THE ESSENCE OF CAPITALISM

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By Thomas K. McCraw

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The Montréal Review, August 2011

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 "Prophet of Innovation: Joseph Schumpeter and Creative Destruction" by Thomas K. McCraw Harvard University Press, 2007)

"This well-paced and beautifully written book explains not only Schumpeter's work but also the fast-changing phenomenon of modern capitalism. McCraw brings out Schumpeter's energy and charisma as well as the power of his ideas, quite skillfully linking the economist's colorful and adventurous personal life with the development of his views. This book is a fine tribute to a great thinker." -- Harold James, Princeton University

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"It's safe to say that since the first appearance of Thomas McCraw's contribution to Harlan Davidson's American History Series in 2000, American business has taken some of the most dramatic, perhaps most incredible, turns in its history. Far more than an update, this edition of one of the most popular texts has been carefully revised and reorganised not only to include necessary new coverage but to present more fully and forcefully the book's central argument and major themes, making this new edition even more teachable for instructors and accessible to student readers." -- Harlan Davidson Inc.

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The worldwide economic downturn is no short-term blip but a full-fledged crisis of capitalism. Amid the din of commentary and political posturing, it is appropriate to return to first principles for a better understanding of the crisis. What are these principles? The answer requires a foray into history.

The word "capital" made its first modern appearance in about 1630. The Oxford English Dictionary gives a concise definition: "accumulated wealth reproductively employed." The term "capitalism" came much later, in about 1850, as an antonym for "socialism." A capitalist system emphasizes private property, a market economy, the sanctity of contracts, entrepreneurial innovation, payment of wages in cash, and -- crucially -- the ready availability of credit. In this last element capitalism goes well beyond the dictionary definition of capital. Capitalism employs not only accumulated wealth but also "money of the mind," as credit has been aptly called. And therein lies the key to both economic growth and potential catastrophe.

Credit stands at the heart of all capitalist economies. It depends heavily on faith in the future, as its Latin root implies (credere, "to believe"). Banks lend funds far beyond their cash reserves, leveraging them in the expectation of future repayment with interest. Corporations do the same thing when they issue stocks and bonds, the value of which depends on the corporations' discounted future earnings. A central aspect of capitalism is persistent faith in a better future -- by bankers, entrepreneurs, and consumers who use credit cards and make big investments in cars and especially houses. Consumers spend money they don't have but expect to earn or inherit. The essence of capitalism, therefore, is a profound psychological orientation toward the future, best expressed in the system's pervasive reliance on credit.  

Despite its many faults, capitalism has been the most productive economic system ever devised, by a wide margin. In The Communist Manifesto (1848), even Karl Marx and Friedrich Engels conceded that a mere hundred years of capitalism had "created more massive and more colossal productive forces than have all preceding generations together." Capitalism is not, however, the natural state of human affairs. If it were, it would have emerged thousands of years ago and quickly spread throughout the world. Instead, it first appeared in modern form in the seventeenth century, and even then only in Holland, England, and a few Italian city-states. So, rather than having a history of several millennia, capitalism has been around for less than 400 years, and during most of that time in only a handful of countries. The United States -- perhaps the quintessential capitalist country -- contained a few hundred corporations during the 1820s, compared to over four million today. So by historical standards capitalism is a very recent phenomenon.

Why did it come so late? In part because its ethos -- the relentless pursuit of material gain -- violates some deep-seated human values. In the sixth century B.C., the Athenian statesman Solon wrote that "many evil men are rich, and good men poor." In China at about the same time, Confucius observed that "the chase of gain is rich in hate." The Old Testament famously warns that "the love of money is the root of all evil." The Gospel of Matthew asserts that "it is easier for a camel to go through the eye of a needle than for a rich man to enter into the Kingdom of God." And the twentieth-century economist Joseph Schumpeter, one of the most astute analysts of capitalism, remarked that "the stock exchange is a poor substitute for the Holy Grail."

For thousands of years before the Industrial Revolution, which started in about 1760, most people believed they should remain in their place and conserve what they had. Striving for wealth struck them as unseemly and irreligious. "There's place and means for every man alive," Shakespeare wrote in All's Well that Ends Well (1602). In almost every part of the world, society was organized on a static basis. Few people anywhere were "free" in the way we think of that term. In 1776, the English economist Arthur Young estimated that 96 percent of the world's population were slaves, serfs, vassals, or indentured servants. Most of the fruits of their labor went to their owners, landlords, warlords, or tribal masters. Prussia did not liberate its serfs until 1805, Russia until 1861. The United States did not abolish slavery until 1865, Brazil until 1888, Saudi Arabia until 1962. Before the arrival of capitalism, agricultural affairs were organized around landed estates, primogeniture, and entailment. In urban areas, commerce and industrial production remained subject to tight restrictions by cartels, craft guilds, and authorities setting "just prices." All of these institutions tended to preserve existing conditions. And all of them lasted longer than capitalism's short history up to now.

As young as capitalism is in western Europe, the United States, Canada, and Japan, modern global capitalism is still in its baby shoes. Only toward the end of the twentieth century did about half of the world's people abandon socialism and embrace some form of capitalism. For the first time in history, most people now live under a capitalist economic system.

Once some form of capitalism finally arrived in China, Russia, eastern Europe, and India, it proved to be an uncommonly difficult system to organize and maintain. The appropriate balance between unfettered business practice (the "free market") and societal control was not self-evident. It never has been in any country, and never will be. Too much government regulation can kill a company, an industry, and even a national economy -- but so can too little. Successful capitalism requires the persistent encouragement of private entrepreneurship, but also constant public monitoring to ensure that the system does not spin out of control. Entrepreneurs, obsessed with future profits, are forever pushing the envelope, moving into gray legal areas and forcing governments to play catch-up. Corporate scandals have been so frequent that they must be regarded as endemic to the capitalist system, especially in finance.  

Why finance? Because that's where the most money is, where credit is obtained, where paper assets can be easily manipulated, and where bubbles originate -- from the Tulip Mania of seventeenth-century Holland to the South Sea Bubble of eighteenth-century England, down to the catastrophic housing bubble of the early twenty-first century.

In that housing bubble, as is well known, the current crisis mostly originated. Banks and mortgage companies aggressively marketed new homes to buyers who had no chance of repaying their huge new debts. Then the banks -- including most of the world's leading investment banks -- bundled these mortgages ("securitized" them) and sold the bundles to investors throughout the world. Because Moody's, Standard & Poor's, and other rating agencies -- which were paid lavishly by the very firms being rated -- awarded AAA status to these new instruments, even conservative investors and institutions purchased them. Each of the new instruments multiplied the traditionally low leverage of bank loans, until ratios reached 30 or 40 to one. This meant that a failure of only three percent of the underlying mortgages could send the bundled securities into default. Meanwhile, the financial sector was inventing and marketing even more arcane derivatives, most notably collateralized debt obligations and credit default swaps. These instruments, most of which were wholly unregulated by any government, mushroomed into the trillions of dollars. When the obligations they represented could not be paid, venerable institutions such as Lehman Brothers, other Wall Street banks, and the insurance giant A.I.G. either went into bankruptcy or had to be rescued by government bailouts.

The crisis spread to Europe and throughout the world, battering countries such as Iceland, Ireland, Greece, Portugal, and Spain especially hard.  Regulators in a few nations, notably Canada, had kept their heads during the bubble. They had cast a skeptical eye as financial innovation ran amok, and had thereby minimized the damage to their national credit markets.

How had regulators in other countries allowed the debacle to occur? Here the answer is surprisingly simple. In the United States, which had possessed an extremely effective oversight system since the 1930s, a "deregulation" craze had taken hold during the 1970s. It had flourished under the "free market revolution" associated with the Ronald Reagan presidency (1981-89). Unusual prosperity during the 1990s had then misled U.S. regulators into believing that the market would correct itself, that vigilance and enforcement could be relaxed, and -- most importantly -- that new financial instruments such as credit default swaps need not be regulated at all.  

This was a deliberate policy decision, and it turned into one of the biggest mistakes in the history of finance. It was fundamentally an error of ideology, and it came in defiance of dire warnings from a few isolated regulators -- people such as Edward Gramlich of the U.S. Federal Reserve System, Sheila Bair of the Federal Deposit Insurance Corporation, and Brooksley Born of the Commodity Futures Trading Commission. Even some experienced investors who had made fortunes on Wall Street, such as Henry Kaufman, Felix Rohatyn, and George Soros (all of whom, not coincidentally, are sophisticated immigrants from Europe who in their youth had witnessed the Great Depression and the rise of Hitler) warned that the system could not absorb the potential shock from so much leverage.

And the shock came, first in 2007 as the U.S. housing boom collapsed, then in 2008, when the international financial system, burdened with absurdly over-leveraged assets, approached the precipice of total collapse. Only massive infusions of public money saved the world from another Great Depression. 

In the wake of the crisis of 2008, one would have expected that a wave of regulatory reform would restore order to the financial sector of every affected country. But one would have been wrong. Ideological opposition and economic ignorance, fed by almost unlimited lobbying funds supplied by banks and other financial institutions, thwarted genuine reform. Consequently, the world economy remains relatively moribund, its financial sectors hostage to still another crisis.  

The current situation could hardly provide a better illustration of the essence of capitalism -- which is faith in a more prosperous future. Lacking that faith, most companies are reluctant to hire and invest because their executives do not believe that sales are going to improve. Consumers are hesitant to buy because they feel a pressing need to conserve their reduced assets. For the first time in the history of polling, large majorities predict that today's children will be less prosperous than their parents. Governments lurch toward the right, more fearful of deficits than of job-creating stimulus packages that have customarily ended deep recessions. Lessons of the past make no dent on the minds of regulation-averse ideologues of the "free market" -- people with the same habits of thought that brought on the present crisis. Large parts of the electorate in many countries remain in a state of denial -- confused, fearful, and somehow convinced that government caused the crisis.

In a sense, it did, not through its action but through its deplorable inaction. Regulators, almost across the board, abrogated their duties -- which had been clearly written into statutory law and had been faithfully enforced in most countries from the 1940s to the 1980s. Since then, financial regulatory agencies -- most notably in the United States -- have been systematically starved of funds and other resources. Often individual regulators have behaved in cowardly fashion, allowing themselves to be browbeaten by financial lobbyists and right-wing lawmakers. For the thirty years preceding the meltdown of 2008, regulators collectively compromised their mandates. Along with many others who should have known better, they accepted assurances that the financial markets were "self-regulating." They bought into assumptions that no sensible banker would risk the savings of his or her institution's investors -- let alone the survival of the institution itself.

A foundational truth about capitalism, however, is that no industry can regulate itself. The pressures for innovation and profit are simply too great -- and never more so than in the present era of global capitalism, when competition is more intense and relentless than ever before. These are the elements that drive the capitalist engine. That engine, pressed harder and harder by competition -- much as in organized auto racing -- cannot prevent itself from sputtering, overheating, burning itself out, or dying altogether. Preventing such outcomes is the task not of business but of government.

So far, bedeviled by ideological confusion and partisan deadlock, most governments have failed -- even in the wake of the 2008 catastrophe. In prior crises, it has taken years to recover from the bursting of major bubbles, and there seems little reason to expect an early rebound from this one. It may take not years but decades. Conceivably it could take even longer. During the Great Depression of 1929-41, someone asked John Maynard Keynes whether any other depression had ever lasted so long.  Yes, he replied. "It was called the Dark Ages."   

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Thomas K. McCraw is the Straus Professor of Business History Emeritus at Harvard Business School.  In addition to the volumes pictured here, he is the co-author or author of ten other books, including  Prophets of Regulation, which won the Pulitzer Prize for History.

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