Who will modulate capitalism: business, or government?

I'll make an educated guess that whatever popular sentiment remained for laissez-faire capitalism is now dead and buried. Anyone who disagrees is free to post a comment. My judgment: the free-market is in for some new controls, like it or not.

To me, the big question is not whether it will happen, but:

How will capitalism be modulated, going forward?

Below is how I picture the problem. The business cycle is a given (...economists don't argue about its existence, or whether it will continue). But society has a limited tolerance for the joblessness and bankruptcies that go along with downturns in the business cycle — and when the downturns surpass that tolerance limit, the people get really, really upset. No surprise.   

The people have now had it with the previous form of capitalism on Wall Street. (Whether or not Wall Street deserves more blame than incompetent regulators and politicians is a valid question, but my guess is that the people will assign the lion's share of the blame to Wall Street.) 

So, the question is not whether, but how capitalism will be modulated differently than it was before. If business cannot figure out how to better-modulate the business cycle, then the public will turn that job over to the government. I hope the former is still possible, but fear the latter may now be inevitable. 

Here's the modulated version:

Too much government intervention will stifle innovation, and therefore long-run growth (blue line). That's why I hope the government's intervention can be limited to "stimuli" that push private business into better practices.

One idea I've mentioned previously ("What shall we do about the board of directors?") is at least a quarter-century old. It's former ITT chairman Harold Geneen's solution to the fox-guarding-henhouse situation in our top 500 corporations (i.e., employees "representing" the owners — the most common example being the CEO's membership on the board of directors, frequently as the chariman). Should there be a new law banning corporate employees from board membership? Geneen thought so, but few if any corporations did anything about it.

One result of that inaction: almost nobody in corporate America who bought into the ponzi scheme of mortgage-backed securities asked the question (...on behalf of their bosses, the stockholders), "What if housing prices went down? What would that do to the risk in these securities, in our portfolio, and on our balance sheet?"

If questions like that had been asked in more companies than just Wells Fargo and (Warren Buffett's) Berkshire Hathaway, we probably wouldn't have moved anywhere near this close to the brink of financial collapse.

An emailer suggested a second possible way for government to stimulate self-modulation in business: Employee-owned stock in major corporations automatically becomes non-voting stock. Employee-stockholders get the owners' upside of success, and downside of failure — but they don't get rubber-stamp approval authority over the way they propose to run their companies for the rest of the stockholders.

I'm sure there are more ideas to kick around regarding better self-modulation by business, but there might not be much time (if any) left for figuring it out. If it can't happen that way, then government will get too big a role. That would definitely gum up the works. Not only would 5% long-run growth become a polyanna fantasy, our track record of 3% growth (blue line above) could easily become a thing of the past — as would the incentive behind this blog.

The business cycle will be modulated differently, that's a certainty. The question is, Who will do the modulating?

Comments

[Steve C]

The interesting thing about shocks like this is it's not like businesses aren't still producing goods people want, or there aren't a whole bunch of skilled people willing to work, or a lack of innovation, etc.

It's simply about credit. Explaining credit - why it's special/weird/etc - is something capitalism's "supporters" haven't figured out how to do very well (and even if they did, one wonders whether anyone would pay attention). It's what gives this Bernie Sanders takedown of Larry Kudlow its oomph:

http://www.youtube.com/watch?v=Lkqb1pQrCcg

None of that socialism talk would have any "bite" if the public - even the chattering class - knew to set aside credit as a special case. Given how prone to turmoil and shocks the credit industry is, and how severe the spillover effects are, I think you can with a straight face be for strong oversight and (well-crafted) government bailout, and not be anything close to a socialist.

Clearly the world hasn't figured out how to let this industry run wild and let the unfettered free market do its magic. It's a complex problem and putting a few independent technocrats in charge seems to be the least bad solution so far. Maybe it'll all be figured out in 100 years.

[goy]

I'd like to respectfully submit the following, because all this economic stuff isn't happening in some sort of mathematical vacuum - it's happening in a politically motivated milieu:

1. The 'Limit of public patience...' line is neither a straight line nor is it objectively calculable.

2. The 'Limit of public patience...' line is nonetheless real, but based on [please fill in the blank] ?

Some food for thought:

1. The unemployment rate under Clinton was generally similar to that during the past 8 years. Which of these was deemed less "acceptable" by the public and how did it shift the "Limit of public patience..." line?

2. The 'boom' of the late 90s was primarily due to Republican passage of the capital gains tax reduction. Who boasts the credit? How did that shift the line?

3. Federal tax receipts skyrocketed during the years following the 2001 tax cuts, yet the public perception (which determines the mathematical "Limit of public patience...' line) is that we're awash in "corporate welfare". How has that shifted the line?

This list could go on, but hopefully you see what I'm driving at.

For public policy on this issue to make sense, two non-economics issues need to be resolved:

1. The media, which has abandoned all pretense of ethical journalism, needs to be held accountable for the effects of their agenda-driven mendacity on the public welfare.

2. Academia, which has abandoned all pretense of classical education (esp. including Econ 101), needs to be held accountable for the effects of their agenda-driven shift toward constructivism and the outcome-based theories that have replaced the educational methods we (those of us who are 50+) were the last to benefit from.

I know it's much more comfortable to pretend this problem can be addressed by bailouts, oversight, self-modulation and comparing Sanders and Kudlow, but unfortunately the "Limit of public patience..." line doesn't give a rat's assets about any of that - it's determined by information provided by the media, as "understood" by the limited facilities produced by today's educators.

It's not that difficult to comprehend what you write about here, Steve. Most folks could see a majority of this for themselves if they (1) had the intellectual facilities and (2) had the facts. At this point most of the voting public, unfortunately, has neither.

[Bob]

I'm not sure totally independent boards are the end all be all. Would such a board have prevented AIG, Lehman and Bear Stearns from blowing up? Not if no one knew how to ascertain the risk of complex financial instruments.

Goy is right about one thing. Political agendas and ideology, played a huge role in all of this. Go back and look at the Community Reinvestment Act, the repeal of Glass-Stegal and the assine mantra of "affordable housing,er, mortgages".

Nevertheless, your question about increased government involvement will be answered with a resounding yes if we have a liberal Democrat President and a fillibuster free Democratic Congress.

[hoffmang]

Echoing the board issue - I'm not so sure that there are any imminently solvable solutions to the board issue set. Can Larry and Sergy be forced off the board of Google after they were forced by SEC regulation to take the company public?

To counterpoint the "out of control" Chairman/CEO meme - would AIG have cratered if Herb Greenberg wasn't forced out in a political witch hunt by the ex-Governor who doesn't know how to dial the 202 area code?

-Gene

[Optimist123]

Gene and Bob:

My feeble two-sentence attempt to summarize Geneen's idea is nowhere near as good as just reading chapter 12 of his book for oneself. "Managing" is available for a song on the Amazon used book market.

Geneen didn't suggest it would be a quick fix, and certainly didn't imply that the majority of CEOs and management teams weren't already placing company first. He just predicted that aggregate productivity would improve significantly, simply by giving owners a more effective check on managers. Independent boards would be better able to reward managers not for how the company performed, but for the difference the managers made in its performance. Obviously a judgment call, but the judging process would be virtually free of any subconscious bias resulting from managers judging themselves.

He did not have a detailed plan, just suggestions for how it might evolve. Trial-and-error will take a while (a generation or two?), but evolution always takes time... if there's still any time left for business to implement self-correction measures, that is. (It's likely that time has run out. If so, this is just an academic woulda-shoulda-coulda exercise.)

[Mike H]

I'm still having trouble digesting the huge shift we are likely about to see. I'm afraid that no matter what the new "tyrant majority" does, the negative consequences will not be felt in 2 or maybe even 4 years between now the next elections. I'm afraid they will be able to argue success since the economy will undoubtedly be better off than the crater we are in now. The business cycle is choosing our new leaders, and is blocking the view of the underlying trend. What are the chances of devastating legislation passed in the proceeding years to be overturned subsequently? It is unfortunate that the real-time economy is judged in terms of real-time leadership, but this has always been the case.

[Jimmy the Dhimmi]

You never did post your views on what caused this mess, Steve. I'm curious as to what they are. Many people blame the CRA refurbishment of 1999 and the FNME and FDMC requirements imposed upon them by the HUD to buy special low income mortgages.

Others point to how higher imcome people created a speculative bubble and the repealing of Glass-Steagal caused the banking system to act irresponsibly.

I'd like to know what's your take on it since you are one of the only economy pundits on the web I trust.

[Optimist123]

Jimmy the Dhimmi:

What caused this mess? This is only my personal judgment, but here goes...

The root cause was a combination of: insufficient internal vetting of financial innovations by the firms that invented them; mismatching of rewards with risks in the sale of those innovations; lazy assumptions by the buyers that the risk of those new securities would be similar to their historical experience; lazy regulators who were both insufficiently skeptical and woefully incompetent; fraudulent game-players on both the buying and selling side of the mortgage business; incompetence on both sides as well; and, last but not least, donation-hungry politicians concerned far more with impressing their constituents and with solidifying their power bases than with protecting the nation from the consequences of what they thought was a virtually-impossible, black swan financial event -- for which ignorance, nonetheless, is no excuse.

I do believe that is the longest sentence I've written in two decades.

[Optimist123]

...follow-up:

The good news is that this is evolution at work in finance and economics. Selection will ensure that mistakes and bad ideas are punished with extinction; firms and financial instruments will adapt based on this bad experience; superior instruments, vetting processes, and regulations will emerge. Darwin's idea applies to the social sciences, too.

I do fear that those processes now face a formidable obstacle, however: "intelligent design economics" -- the idea that an army of government policymakers and regulators knows what's best for the economy. I think Marx was the first one to articulate intelligent design economics, by the way.

[Laissez Faire]

Federal receipts in year 1929 was $3.8 billion. Let's just say dollar lost 95% of the value since then. Multiplying that $3.8 billion with 20 would get us $78 billion. If government was of the same size it was back in 1929, federal budget would be around $78 billion. Laissez Faire Died a few decades ago. Didn't you get the memo?

If dollar lost 99% of the value then that would allow for a $380 billion federal budget.

Federal budget was 3% of the GDP back then.

Some positive signs in favor of Laissez Faire are these:

Popularity of Austrian School on the internet.

1) According to Alexa.com, outside of government economics stats sites, Austrian school related site are some of the most popular websites.

2) If you dig down deeper into a category called schools of thought, 18 out of the top 20 websites are related to Austrian School. 20th one unfortunately is marxist.org.

3) Austrians are the only free-market types with any credibility, given the current turmoil as the "Greatest story never told" types are still trying to come out from underneath the pile of rubble they are buried under.

4) Mises.org is giving away books on the internet for free for those who wants to study economics as a logical/common sense subject, rather than a "lies, damn lies and statistics" subject.

5) Mises.org is the most popular economic site on the internet dedicated to publishing works in economic thinking.

6) At least some people are getting educated in the truths of laissez-faire as philosophized by Menger, Bohm-Bawerk, Say, Turgot, Bastiat, Mises, Hayek, Kirzner, Rothbard, Reisman, Garrison etc.

[Optimist123]

LF:

The Austrian school taught me a lot; I still think Hayek's essay "The Use of Knowledge in Society" is one of the most important documents I have ever read, largely because it describes why top-down economics will nearly always fail, and why the wisdom of crowds will almost always be the superior alternative. In essence, it describes how the evolutionary processes of selection and adaptation apply to economic society just as much as they do to biology.

The big weakness of the Austrian school is monetary economics, in my judgment. It rests on the assumption that any increase in the money supply is inflationary (see Mises' book, The Theory of Money and Credit, p.251: "Inflationism is that monetary policy that seeks to increase the quantity of money."). That is simply absurd -- because it requires two absurdities to be true: the velocity of money must be a constant, and society must readily accept wage and price decreases as the real economy grows. As for the constant-velocity assumption: current events (the credit freeze, i.e., velocity drops to near-zero) should eliminate any remaining doubts about its absurdity. The falling-wages-no-problem assumption has been absurd for quite a while (...test it by trying to convince a few friends that they should be willing to take a wage/salary reduction now that the prices of groceries and gasoline are falling).

Again, Hayek is one of my favorites. But I've moved beyond the Austrians' outdated monetary theory. It puzzles me why so many still cling to it, but that's their choice.

[Laissez Faire]

Monetary theory is one of the biggest of Austrian School. The Mises-Hayek business cycle theory rests on the monetary theory.

Money supply grows even under a gold standard. History shows that the total supply of gold( assuming a gold/commodity standard ) grows at about 1-1.5% per year, pretty steady, with some once in a century or couple of centuries surge to probably 5-6% growth.

Small growth in money supply doesn't mean falling nominal wages, it just means rising purchasing power of wages. The 100 years from 1820 to 1920, the real price of goods fell by about 35%. In fact period of late 1800s, the U.S experienced China like growth rates, without computers, petroleum, automation, or even assembly line.

Rising value of money gives people an incentive to save and invest, rather than borrow and consume. It is the supply that creates demand, and it is not the other way.

Here is a suggested reading list on monetary theory, business cycle, inflation/deflation, prices & production.

[Laissez Faire]

Forgot to attach, link to the reading list. Steve, I also want to thank you for the response to my post.

http://mises.org/story/3128

[Optimist123]

LF:
Please read Hayek's "The Use of Knowledge in Society" ( http://tinyurl.com/2vq524 ). It is brilliant, it is true, it should be required reading, and it says nothing about monetary theory. It does point out the problem with the arrogance of assuming that economic aggregates enable effective policymaking from government ivory towers -- that's why I find it ironic that many advocates of laissez-faire think they are wise enough to know that a steady 4% money supply growth would be just right for the economy. Not only does that stifle growth when the real potential is more than 4%, holding to 4% also destroys the economy when money velocity drops to near-zero. When economies get destroyed, governments get overthrown -- and there go the bureaucrats who thought "steady 4%" was a good idea.

In short, regarding Austrian monetary theory: I've read it, I understand it, and I disagree with it -- notwithstanding the Ron Pauls who just can't let it go, largely because they can't seem to admit that money velocity varies more, especially in the short term, than they'd like it to.

The money supply must grow at the same rate as the real economy in order to achieve 0% inflation -- according to everybody except those who subscribe to Austrian monetary theory, which defines "inflation" as "money supply inflation" instead of "price/wage inflation." If the real economy can grow at 2%, or 6%, or 12%, then the money supply must grow at those same respective rates. If money velocity suddenly drops to 1/2 or 1/4 of its average rate, then money supply must temporarily be doubled or quadrupled just to break even.

Credit freezes can and do happen in the short run -- even if they aren't accommodated by the long-run assumptions in someone's monetary theory. And when velocity drops to zero in the short run, it destroys the economy. Who cares if an airliner achieved an average altitude of 10,000 ft -- if it achieved that "average" by flying at 10,100 ft for four hours, then crashed into the ocean (altitude = 0 ft)?

Regarding the "purchasing power" of a deflating (strengthening) dollar: As I said before, try convincing a few friends and neighbors that they should be perfectly happy to accept a wage cut, as long as they could buy the same amount (or more) of gasoline, food, and computers with their new, lower wages. Use your purchasing power argument, and see if you can convince them that a 3% pay cut each year would be a good idea (3% pay cut = 5% real growth minus 2% money supply increase). My prediction: you will *not* convince them, no matter how logical you think your purchasing power argument is.

[BoricuaX35]

Steve,

I disagree with a basic assumption of your two diagrams. Specifically, you pictorially propose that regardless of whether capitalism is "modulated" (or "constraining the excesses of capitalism"?), the long-term growth will remain the same - or about 3% a year. If this assumption is true, then we should NEVER have "unmodulated" capitalism. In fact, based on your logic, why not increase regulations to the point where we have no booms and no busts, and always grow at a steady 3%?

Of course, we know that's impossible. But therein lies the error of your assumption. As you increase regulation, you decrease the chance of creating innovation that will produce wealth and economic growth. This is precisely what has happened in Europe, where increased regulation of the economy has decreased the long-term growth trajectory. So I think you should change your charts to indicate that increased regulation/control of the free market likely leads to a lower long-term growth pattern (what the exact numbers are, of course, depends on the type/extent of regulation).

The reality of "private sector modulation of capitalism" is that it already occurs within capitalism...capitalism contains its own well-functioning self-disciplining mechanisms most of the time.

In my opinion, it is when the self-disciplining capitalist mechanisms are removed by a non-market force that you generally have "market failures." But note that most "market failures" occur precisely because the market was not allowed to work.

For example, I think that the current recession/credit crunch/housing bust (each caused by the previous) was caused precisely because the politicians meddled in the housing market - because they did not like the housing market outcomes. At the center of this whole 'recession/credit crunch/housing bust' mess (besides the Fed's inflationary policies of the last 8 years) are the GSEs, Freddie and Fannie. The pols wanted more "affordable mortgages," aka "subprimes," aka "toxic waste." So they passed legislation (CRA and the 95 amendments) that required banks to issue more "affordable mortgages." Then in 97, Fannie started buying up the "affordable mortgages" to encourage more of these loans for a political result - higher home ownership rates, especially for minorities. When Fannie started buying up the subprimes, they broke the self-disciplining mechanism of the banks of making these types of loans; in the past, the banks would be stuck with the mortgage they issued for 30 years, so they had a BIG incentive to vet the mortgagee. So when Fannie started gobbling them up en masse, banks were free to originate these subprimes with little care as to whether the mortgagee would actually be able to pay off the loans (since the originator would immediately off-load them unto Fannie).

Well, those are my general thoughts on your proposed "modulated capitalism."

I think that the TRUE question is how much long-term growth (if any ;-) are we willing to give up for a more restrained boom/bust cycle.

Sincerely,

Jose

[Optimist123]

Jose:

One weakness of the graphic is just what you hit on: the difficulty of showing other overall growth rates (blue line).

You're right, it's important -- but I think growth could be enhanced instead of retarded, with the right kind of self-regulating innovation by the private sector. (It would look like a tighter sine wave around a steeper-sloping blue line.) The "old" way of assessing the risk of new financial instruments is now exctinct, and the "old" way of decoupling the reward for success from the penalty for failure is also extinct. That's evolution at work. The system will be better off because of it -- if the system survives the shock it must absorb from the failure of one of its components.