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The End of American Capitalism?

Friday, February 6, 2009

Has the government 'bailout’ been so large that capitalism’s founding principle is now irretrievably lost?

There is no surer route to misunderstanding the recent financial crisis, and to prescribing the wrong solution, than to blame capitalism.

No question, the crisis is a frightening economic drama. So many conceits of modern economics have been swept away. Effective countercyclical management has proved to be far more difficult than even most skeptics had thought. The business cycle clearly has not been tamed.

Our securities markets, for all their unprecedented sophistication, proved unable to evaluate increasingly complex risks because their underlying assumption—that markets will always behave in rational ways—turned out to be false. So did our belief that packaging loans into securities and then slicing and dicing them to appeal to different types of investors somehow would disperse rather than concentrate risk.

Much of the blame belongs with those who created certain financial instruments, and with those who misjudged them. But much more lies with government.

We wrapped ourselves in an intellectual security blanket sewn together by our brightest economists and many of their mathematically gifted progeny, the Ph.D. “quants” of Wall Street. We were taken in, as we so often are, by an inflated belief in our own powers. And hubrisas always—was rebuked with catastrophe.

Is It Capitalism’s Fault? 

But to blame this mess on capitalism is not merely to miss the point. It is to spin it 180 degrees in the wrong direction.

Reasonable people might disagree about the specific causes of the current crisis. But there can be no doubt that the housing credit markets were at the rootand the complex securities backed by subprime mortgages the most important branch. The meltdown of those markets provide a perverse lesson in the ability of financial entrepreneurs to make risk so opaque that even the most intelligent, most sophisticated, and most experienced financial minds could so badly misjudge matters of professional life and death. As a result, institutions built on trust have vanished overnight. Surely, much of the blame belongs with those who created these instruments, and with those who misjudged them.

But much more lies with government.

If too many of our larger firms become wards of the government for too long, that could politicize credit decisions and tilt the economic playing field away from entrepreneurial endeavors.

It was politicians, after all, who were determined to raise the home ownership rate from an already robust 64 percent—the highest in the developed worldto 69 percent or more (in retrospect, we probably would have been safe at 67 percent, given the current income distribution, but that extra 2 percent sent us over the proverbial edge). And it was government that pushed financial institutions to keep lending to ever riskier borrowers in order to achieve that goal.

Government created Fannie Mae and Freddie Mac to “liquefy” the mortgage marketto buy mortgages and later to package them into securities. For decades, Fannie and Freddie limited their activity to prime mortgages. But at the behest of Congress and the administration, the two “government-sponsored enterprises” began buying subprime mortgages, to their ultimate regret. And now, to everyone’s regret, as the American taxpayer is on the hook for all of Fannie and Freddie’s losses.

More broadly, no serious observer can dispute the importance of government’s oversight role. Capitalism only delivers what it does best—efficient resource allocation and economic growth—if government establishes appropriate rules of the road. One of those elementary rules is that actors in the economy must have some “skin in the game” when they buy or engage in some economic activity. Otherwise, they will fail to act prudently, and society will pay for that imprudence.

Capitalism and its virtues are so well ingrained in our national psyche that, despite our temporary foray into government-mounted rescues, Americans will continue to embrace the entrepreneur.

Our government failed to ensure that this elemental rule was in place and was enforced at each stage of the mortgage finance process. Homebuyers who were allowed to put nothing down when buying a houseor even choose to add some of their monthly mortgage interest to the principal balanceessentially had little or no incentive to limit their borrowing to amounts they could reasonably expect to pay back. This was especially true given the widespread belief among homebuyers and lenders that home prices would continue climbing forever, allowing all parties to believe that the market would create equity almost ex nihilo, without saving, sacrifice, or effort on the part of buyers.

Likewise, the commercial and investment banks that packaged and securitized subprime debt lacked incentives to scrutinize quality when selling the securities off to investors. Ditto, of course, for mortgage brokers, who got paid simply for originating loans. Why should they have cared about, much less actually investigated, borrowers’ creditworthiness when they knew that the loans would quickly be sold to the securitizers, relieving them of all risk?

Perhaps most consequential of all, government failed in its essential role of ensuring that both commercial and investment banks had sufficient amounts of shareholders’ skin in the game (equity) relative to the banks’ liabilities. Able to take risks with so much leverage, the banks had little incentive to behave prudently. And so they didn’t.

Large commercial banks, in particular, were allowed to end-run bank capital standards by forming supposedly off-balance sheet “Structured Investment Vehicles.” But they paid dearly for that maneuver when, as the residential real estate market began to cool, creditors refused to finance the SIVs, leaving the banks with no choice but to take these supposedly off-balance entities back on their balance sheets to preserve the banks’ reputations with their customers.

Our securities markets, for all their sophistication, proved unable to evaluate increasingly complex risks because their underlying assumption turned out to be false.

Meanwhile, the large, independent and once-proud investment banks were permitted to leverage their equity by unprecedented, hair-raising ratios—30 to 1 or more in some cases—and to finance their swollen balance sheets with very short-term (often overnight) money. That business model, again allowed by the government, proved to be disastrous when panicked creditors no longer were willing to finance what was little better than a pyramid scheme. The two investment banks that neither failed nor were forced to sell, Goldman Sachs and Morgan Stanley, survived only by turning themselves into conventional banks, thus giving them shelter from future financial storms by the Federal Reserve.

To be sure, other villains will emerge as the blame game plays out. But not, if we are honest with ourselves, capitalism. To the contrary, government failed to provide the proper legal and institutional environment for capitalism or markets to operate properly in mortgage finance, especially for subprime borrowers or lenders. We have just witnessed how much damage this “government failure” can cause.

Will the “Cure” Kill Off Capitalism?

But what about the steps taken to contain the crisis? For instance: the steady expansion of the Federal Reserve’s lending to new “customers” (investment banks, insurance companies, and the commercial paper market); the federal rescue of Fannie Mae and Freddie Mac; the inducements for mortgage lenders to modify delinquent mortgages to avoid foreclosing them; and the $700 billion elephant in the room, Treasury’s TARP (Troubled Asset Relief Program), which conceivably could be expanded. Has government now done so much to “bail out” various actors from their mistakes that the founding principle of capitalismthat private actors not only reap the rewards of their success but also bear the costs of their mistakesis now irretrievably lost? Or, as one investment banker who was critical of the $700 billion rescue package aptly put it: Do we now have capitalism on the way up, but socialism on the way down? Is profit private but loss now public?

There is at least one reason for being optimistic: policymakers now are well aware of the dangers of tilting too much of the economy’s scarce resources into housing.

These are central questions for many reasons; one in particular stands out. As we have written elsewhere, we believe one of the major reasons for the resurgence in productivity growth in the 1990s and through much of this decade was the transformation of our economy from managerial capitalism dominated by large existing firms (think Big Autos, Big Steel, the old AT&T, and the old IBM) into a vibrant form of entrepreneurial capitalism powered by new high-growth firms (think the younger Microsoft, Intel, Cisco, and Google). If too many of our larger financial and nonfinancial firms become wards of the government for too long, we fear that could politicize credit decisions and tilt the economic playing field away from entrepreneurial endeavors. Large enterprises whose creditors know they will be protected if the firms run into trouble are more likely to take imprudent risks and put U.S. taxpayers in jeopardyas we have learned too well with Fannie and Freddie.

We are cautiously optimistic, however, that once this crisis passes, the government not only will be able to extricate itself from its ownership stakes in the companies it is now rescuing, but market discipline to a large degree will be restored. After all, the United States had plenty of market discipline after the Reconstruction Finance Corporation, created during the Depression to prop up ailing banks and other firms, went out of business in the early 1950s.

Furthermore, the current crisis should be seen as the financial equivalent of a 1-in-100 year flood that is unlikely to be repeated any time soon. With the exception of massive regulatory forbearance granted to insolvent thrift institutions and government aid provided to Chrysler during the 198082 recession, the federal government has not injected federal monies into financially threatened firms in past recessions. It therefore would be imprudent for even our largest firms to expect federal rescues in future recessions. And even if future rescues take place, shareholders are likely to take heavy hits first, while executives either will be ousted or have their pay constrained, as has happened during this crisis. In short, the various “bailouts” should not undermine market disciplinea core feature of capitalism however one defines itgoing forward.

But what about the coming overhaul of financial regulation that Congress and regulators are virtually certain to implement as a reaction to the subprime mortgage fiasco? Will policymakers only fix what needs to be fixed by adopting rules that reinforce market discipline? Or will they go too far and excessively burden our financial institutions with a mound of red tape and sanctions for future mistakes that discourage them from lending?

Actors in the economy must have some ‘skin in the game’ when they buy or engage in some economic activity. Otherwise, they will fail to act prudently, and society will pay for that imprudence.

On this critical question, we will just have to wait and see. The answer matters a great deal to current and future entrepreneurs, many of whom rely on credit card and mortgage loans to launch their companies and on conventional business loans to finance growth thereafter.

There is at least one reason for being optimistic: policymakers now are well aware of the dangers of tilting too much of the economy’s scarce resources into housing. As a result, at least in principle, more of the nation’s savings should be available in the future for financing investments in the rest of the “real economy,” in the formation of new companies, and in the expansion of others. It’s one of the few silver linings in the horrible dark cloud of the subprime mortgage fiasco and its aftermath.

Looking Ahead 

There are other reasons entrepreneurial capitalism, in particular, should have—and indeed must have—a bright future.

First, because history tells us so. Time and again, entrepreneurs have led the way out of past economic downturns. Current business legends like Microsoft, Federal Express, Intel, Charles Schwab, and Southwest Airlines started in recessions or down markets. Indeed, 18 of the 30 companies that make up the Dow Jones Industrial Average were launched in recessions or in bear stock markets. As Vivek Wadhwa of Duke University and Harvard Law School has pointed out, the pioneers who launched these firms (and others) during the darkest of times realized the following advantages of starting a business in a recession: less competition, lower costs, ease of recruiting employees, and less pressure to expand. To be sure, formal venture capital and other outside financing is more difficult to get in recessions, but the best research we have seen documents that the vast majority of high-growth companies are not funded by venture capital. So remember: out there in garages throughout the country are entrepreneurs right now who are building the companies that will help lift our economy out of this recession.  

It was government that pushed financial institutions to keep lending to ever riskier borrowers in order to push higher rates of home ownership.

Second, the United States needs continued rapid growth that only entrepreneurs, who are disproportionately responsible for the radical innovations that drive growth, can provide. Growth is essential not only for reducing poverty and advancing overall living standards, but to generate the resources to help finance needed improvements in our public infrastructure and the looming burdens of our main entitlement programs, Medicare and Social Security. (Of course, rapid growth alone won’t finance the benefits under these programs, so we must eventually reform their structure and how they are financed.)

Third, we need novel solutions, which are most likely to be developed and commercialized by a new wave of entrepreneurs, to our most pressing social problems: rapidly rising healthcare costs, poorly performing schools, and the need to move away from fossil fuels. The right policy environment will accelerate these outcomes.

In pursuing healthcare reform, for example, we must find a way to give incentives to consumers and their insurers or health plans to shop for cost-effective healthcare. In education, we need to give the authority to school superintendents and principals that their counterparts in the private sector have: to hire and fire teachers and to pay them commensurate with their performance. And to move away from fossil fuels, we need to embrace market-like solutions, including cap-and-trade programs, to give incentives to consumers to conserve and to provide producers of alternative energy more appropriate market signals that their technologies will survive in the market. We may also want to use the tax system to establish price floors for fossil fuels, to provide further comfort to entrepreneurs that the funds they and their backers invest in alternative energy technologies will not be wiped out by huge swings in oil prices. Taxes supporting a price floor would also keep more of the money spent on fossil fuels here in the United States rather than being shipped to oil-rich countries abroad.

Admittedly, each of these ideas is controversial and faces significant political hurdles. We may never get any one, let alone all of them. But even if we don’t, entrepreneurs have a knack for figuring out ways around obstacles, be they legal or institutional. Thus progress in addressing each of these social challenges will be made, although the right policies will bring better outcomes sooner.

Effective countercyclical management has proved to be far more difficult than even most skeptics had thought. The business cycle clearly has not been tamed.

Critiques of capitalism, especially during times of economic distress, will always be a feature of our democracy. But capitalism and its virtues are so well ingrained in our national psyche that, despite our temporary foray into government-mounted rescues and important philosophical differences between our two political parties, we remain confident that Americans will continue to embrace the entrepreneur.

Shortly after the $700 billion financial rescue plan was announced, our foundation commissioned a national survey of the public’s attitudes toward capitalism and government. Amidst a highly charged political campaign, a sharply declining and volatile stock market, and growing public concern about the economic downturn, the findings were reassuring (to some, perhaps surprisingly so). Over 70 percent of the respondents expressed their faith that private firms, rather than government, would get us out of the recession.

So, the public commitment to an entrepreneurial economy is very much alive and well, even if, as our survey also found, individuals themselves are pessimistic about their own intentions to start companies in the current climate. As our policymakers go about the task of “fixing” our financial system and broader economy, they would do well to keep these findings in mind. The tools in this crisis should not include a meat axe that kills off entrepreneurship as a byproduct of effecting revenge on the leaders of failed or troubled financial institutions. 

The most important citizen is not the politician, nor the big businessman, nor the bankers on Wall Street. They are important but not central to the renewal of democratic capitalism. That role, that burden, that honor falls to our fellow citizens who in the face of the challenges we see all around us are ready to pursue what it is that entrepreneurs dobirth the new, create our jobs, and make the wealth that will be more necessary than ever to purchase a prosperous future.

Carl Schramm is president and CEO of the Kauffman Foundation and a Batten Fellow at the Darden School of Business at the University of Virginia. Robert E. Litan is vice president for research and policy at Kauffman and a senior fellow in economic studies at the Brookings Institution.

Image by Darren Wamboldt/The Bergman Group.

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