Does the Financial Crisis Mean that Capitalism has Failed?

Not really; it is more a failure to manage it properly. Capitalism is based on the idea of competition in a free market, which is fundamentally flawed: what many free-marketeers have forgotten is that competition naturally leads to one winner and lots of losers, so that the normal tendency of free markets is to result in monopolies. The competitive stage of a completely free market is a transient one! Hence for capitalism to be successful it needs to be actively managed in order to prevent single companies becoming too powerful (which is why every capitalist economy has its equivalent of the Competition Commission). Unfortunately, due to the popularization of ideas such as the Nash Equilibrium which were used to promote the free market, actively managing economies fell out of favour in the 1980’s under president Reagan and Margaret Thatcher. Mrs. Thatcher’s famous quote “There’s no such thing as society” was a reference to John Nash’s work which had been taken to mean that if you de-regulate and just let everyone get on with pursuing their own self-interests, things naturally settle down to a stable state. Except that life is much more complicated than game theory models and, in reality, they don’t. This can be seen in post-Perestroika Russia, which was advised by US free market economists at this time on how to liberalize its economy, so that we now see wealth and power there in the hands of a few so-called “oligarchs” (an incorrect use of the term) and organized crime gangs.

While legislating against monopolies and anti-competitive practices is important in managing economies, there is also the issue of money. In our modern, fiat money system, where your pound or dollar is not backed by anything tangible (such as gold) and therefore has no intrinsic value, it is up to governments to decide how much of it to issue. They also decide what interest rate their central bank will charge for loans to commercial banks. These decisions are very important in the management of an economy, and, as we are seeing now, cause tremendous damage when got wrong. During the 1990’s and early 2000’s interest rates were kept unreasonably low in order to encourage borrowing and spending as a counter to the deflationary effects of cheap Chinese imports. While this achieved its aim of keeping inflation positive, the abundance of cheap credit also encouraged banks to speculate excessively, leading to a bubble in house prices on both sides of the Atlantic. When the realization eventually came that banks had “invested” in too many mortgages which weren’t going to be repaid (the sub-prime crisis) there was a domino effect where banks weren’t sure of the soundness of each other and were afraid to lend (the credit crunch). This led to the recession of the late noughties. This sort of thing has happened before: the Great Depression was caused by excessive bank speculation in shares, causing a stock market bubble in the late 1920’s which burst in 1929. The US government introduced the Glass-Steagall Act in 1933 to separate commercial and investment banks in order to prevent the fallout from such excessive speculation from seizing up the banking system, but in a concession to the Nashite free-marketeers, this act was repealed in 1999 and within ten years history repeated itself.

This illustrates a fundamental problem with democracy; while economic cycles take decades, electoral ones take only four or five years. Had governments remembered that interest rates need to take into account savers as well as borrowers, this credit boom could have been avoided. But democratic governments have to court public popularity and putting up interest rates would have made it harder for people to exercise their human right to buy a house or obtain the credit to buy all the other material goods they think they need in this modern world. So sound economic management gives way to appeasing the electorate for short term electoral gain. No doubt the politicians involved would justify what they did by saying they were producing economic growth, but growth bought on credit is not real; it is effectively just brought forward from the future. We are now faced with a significant period of contraction as all the resultant excess debt, and the growth it gave us, has to be paid back.

Andrew Edgington – October 2011

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