“..the rulers of the exchange of mankind’s goods have failed,” said Franklin Roosevelt in his inaugural address during the Great Depression of 1929. He went on to criticise not only the people controlling the system for the tragedy of unemployment, home foreclosures and loss in financial savings of common people, but also blamed the system. He argued to “safeguard against the return of the evil of the old order” and emphasised the need to “apply social values more noble than mere monetary profit”. However, after a decade of recession, post war recovery in the global economy put to rest all criticisms of the system. Capitalism is once again under attack and questions doubting the sustainability of the system are being raised. Some have even declared that this system which has been the modus operandi in most parts of the world is now dead. Indeed the markets have stopped functioning and the scale and depth of losses is unparallel, however, capitalism as an economic system has been through similar times and similar questions have been asked earlier. In the past, most of these concerns have been laid to rest by economic recovery as well as by the failure of all alternative models. I believe that the current economic turmoil is not a cause of the capitalist system but rather an integral part of its functionality. It was the unfounded belief of the policy economists that business cycles have been tamed, which has been one of the causes of the crisis. In this article, I have traced the origins of the recessions to support the argument that a recession was inevitable. I have also discussed the structural factors which have made the cyclical recession deeper.
Capitalism and the role of the State
Before we can even initiate on any kind of discussion, it is necessary to define capitalism. The capitalist system, as we know today, has evolved a long way from the theories of Adam Smith (who proposed that self-interest rather than government direction would maximise efficiency) and Max Weber (who proposed market exchange as the defining feature of capitalism compared) to the concept of Laissez-faire, which has been proposed, defended and restructured at various times in history (from the French to the Austrian School to the Monetarists like Milton Friedman). For the discussion for this article, I would use the term capitalism as an economic system where the market decides on the prices of factors of labour, without any control or direction from the State. This implies that the profits (or interest rates) for capitalists and wages for workers will be determined by the interaction of demand and supply in their respective markets. Indeed, it will be unfair to call the reigning economic system a pure capitalist structure but the role of the state has been limited to ensure that the markets function smoothly and market failures and inefficiencies are minimised.
Business cycles are an inherent part of the free market economic system. Period of economic growth are followed by periods of contraction. The role of the State in this system is to ensure that the cycles are smooth and neither the boom nor the bust is prolonged. After the Great Depression of 1930 the weakness of the capitalists system especially its ability to self regulate and the need for an aiding State role got widely established. Keynes highlighted the significance of government fiscal spending to stimulate aggregate demand in the economy. However, the crisis of 1930 also showed that intervention by the State can also worsen economic recessions. In fact, many argue that the recession became a crisis because President Hoover’s economic team made a policy blunder and restricted money supply which further acerbated the situation. The Great Depression proved to be only a temporarily set back to the capitalist system. The World Wars provided the fiscal stimulus which Keynes was proposing and brought the economy out of the recession. Since 1930, the dominant global economic system has been a mixed system where markets are left to decide the allocation and set prices of factors of production and the State has to ensure that market failures like information asymmetry and externalities are resolved and provide a constant regulatory vigil. As I shall explain later, recessions are a natural process of the capitalist system. Whereas recessions are normal, crisis are often caused by unchecked periods of economic growth, which are in retrospect called bubbles. The regulator and State is often biased towards growth, which lays the seeds of its own destruction.
Economics of business cycles and the crisis of 2008
Over the last five years, the global economy had its longest period of expansion. From 2002-2007 the global economic growth averaged at 5%. Consequently the financial markets also rallied inline with the growth in the real economy, leading to what was being called a super bull run in the financial markets. Usually economic cycles average around 2-3 years. These business cycles have a self stabilisation mechanism, which works through the interest rates and guides the economic growth in a cyclical pattern. An economies total output, or total income which is also called GDP is a sum of the total spending by consumers in the country, its government expenditure, total investment and net exports. In capitalist societies, growth in private consumption is the major driving factor which drives the GDP growth. The GDP grows when private consumption rises and consequently falls when consumer demand recedes. Investment or Savings improve GDP as they lead to greater consumption in the future (i.e. what you save today, you consume tomorrow). People consume more when interest rates are low and when credit is easily available. When interest rates rise, people find it more rational to postpone current consumption by increasing savings. Hence, growth in the economy is linked to the level of interest rates. The expansionary phase in the economy is often triggered by low interest rates, which stimulates private consumption and expands aggregate level of demand. As demand grows, people demand more goods and services and start spending more, hence increasing the money supply. Supply starts to increase and the total level of production in an economy grows. Factories start to produce more and earn higher profits. More workers are given jobs and the level of unemployment starts to fall. However, the growth in supply cannot match the growth in demand, since the supply is constrained by bottlenecks and capacity limits. Soon, there is more money chasing fewer goods. Prices of goods start to rise as demand exceeds supply. Similarly as the number of workers in an economy is also limited as the economy approached full employment levels, wages start to increase. The demand-supply imbalance in the factors of production leads to inflationary pressures. This rise in inflation erodes purchasing power as well as leads to a rise in interest rates since the supplier of capital demand more for their capital investment. As interest rates start to rise, private consumption cools down and aggregate demands start to shrink. This leads to a recession in the economy, until the supply and demand are brought back into the balance. Similarly, when inflation and interest rates fall below their “normal” levels, they stimulate aggregate demand again and boost the economic growth. This cyclical pattern of demand and supply imbalances in the output, money and labour markets ensures that the economic business cycles remain in check and run smoothly. The role of the State has been to ensure that the economy does not overheat during the expansionary phase. Periods of economic growth are prone to irrational exuberance and creation of bubbles. The State has to ensure that the market mechanism of expansion and contraction works smoothly and the recessions are a soft landing than a hard crash. The current crises, as well as the crisis in the past have been caused by a failure of the State to place controls over period of economic growth. There seems to be an inherent pro-growth bias in the State machinery. The similarities between the crisis of 1930 and the crisis of 2008 are striking and will be the topic of my next article. I believe that the growth cycle of 2002-07 got overstretched due to globalisation, triggered by WTO and integration of Asian markets like China and India. This led to an over heating in the economy. Along with this cyclical pressure, structural failures like the inability to quantify and control risk which has been the primal cause of the current crisis.
The super growth cycle of the last five years was stretched due to what was being called by economists like Stephen Roach of Morgan Stanley as a global economic disequilibrium. After dot-com crisis the US economy (which is the anchor economy for the rest of the world) was facing recessionary pressures. Consequently, the Fed reduced the policy rates in order to stimulate aggregate demand in the economy. Growth in aggregate demand started to push the economic growth levels by increasing the production levels. As explained earlier, growth in production level is capped by capacity constraints, which leads to a rise in inflation, since labour, raw materials and production capacity are limited. However, this time, the world benefited from synergies of global integration. Businesses were able to use excess capacity and excess labour in countries like China and India to expand production, without feeling additional cost pressures. Similarly in the capital market, the cost of capital or interest rates, remained low as excess savings were now available from China, Japan and later Middle East. As a result global production levels kept on rising. Whereas the global economy benefited from the gains from integration, the impact on different countries was varied. Global integration led to a shift in production from the US to Asia. As a result, wage growth in the US remained stagnant while unemployment fell in countries like China and India. Similarly, the shift in production base, made itself visible in trade accounts, which showed large surpluses for Asian economies while the US had one of the largest trade deficits in its history. However, since the US remained the dominant global anchor, most of the capital which went to the Asian economies, was recycled back in the US through purchase of US Treasury Bills. This kept interest rates in the US low and the consumption boom continued unabated. Low interest rates, along with a healthy economy, led to build up of both consumer and corporate debt. Usually in a closed economy, interest rates play the deciding role between consuming today or saving for tomorrow. However, in this new global economic era, interest rates lost that role. US consumers could continue their consumption binge on the back of Asian savings. This imbalance in capital and production markets was responsible for the growth and later for the consequences which we face today.
Since everyone enjoys when the sun is shining, there was little economic regulation to correct the imbalance. The man in charge of Fed, Alan Greenspan sang laurels of the flexibility of the capitalists system even during an age of turbulence. The cracks in the global economy started to appear, when the global economic capacity started to reach its capacity constraints. Wages in China and India started to increase and increase in production levels started to inflate commodity prices. This rise in global commodity prices started to put pressure on cost of doing businesses and led the Fed to finally start raising its policy rates, in order to cool down the economy. Indeed inflationary pressures were amplified by speculative demands, however, that only created the froth on the fundamentals. Speculation can not be blamed for the rise in commodity prices.
The correction for the super bull-run has been steep and deep. A consequence of availability of excess labour and excess capital was that the wage growth in US remained low, while the level of debt, both consumer and corporate kept on rising. The first signs of crisis started in the sub-prime mortgage markets, where defaults started to rise. During the bull-run, low return on capital, had forced the inflow of money into more risky asset classes and had led to the invention of products like CDO and ABS. A shadow banking system had emerged. Now not only banks, but also hedge funds, pension funds and other institutional investors had invested in the mortgage market. Whereas the banks were subject to regulatory oversight, the show system avoided any limitations. The failure in one market started a chain reaction, which caused a complete stand still in the credit and money market. Most of the risk models in use by financial institutions were based on historical distribution of returns and had never dealt which these scenarios. Banks were not able to ascertain their value at risk which led to a collapse in investor confidence. The lack of transparency and visibility on financial sector risk levels, led to a sharp increase in the inter bank lending rates and created a liquidity crisis in the financial system. The Fed was unable to react to the severity of the problem and eventually let Lehman Brothers go under, on the fear of not creating moral hazard problem for the banking system. The recession in the real economy further deepened as capital became unavailable or became extremely expensive. This in short is the narrative for the turmoil which we currently face.
The key arguments which I intend to propose are:
1) The current recession is the natural outcome of an extended economic boom cycle. A global economic slowdown and depression in the US was imminent.
2) The recession has become an economic crisis, because of the lack of visibility on risk levels and excessive leverage in the developed economies.
Based on the above two observations, my argument is that the current economic recession is a natural outcome of economic business cycle, but it has been further exacerbated due to lack of regulatory supervision and quantification of risk. This implies the following:
i) There is a need for a global regulatory body.
Now let me defend my arguments.
Economic slowdown was long expected and overdue
A slowdown in global economic growth was long overdue. Not because there was something inherently wrong with what was happening in the economy, not because of some “fraud” by bankers and not because of the speculation of “evil” greedy hedge fund managers but, simply because this is how markets and economy works. Indeed, as Paul Krugman argues in his book The Return of the Depression Economics and The Crisis of 2008, one of the biggest mistakes of economists has been to believe that business cycles have been tamed. The alternations of recession and expansions have been going on since more than a century, ever since modern economies adopted the capitalist structure.
The extra-ordinary growth in the global economy had to lead to inflationary pressures and consequently a slowdown was expected. Perhaps it was complacency on behalf of the State and regulatory insight, on the back of a belief that business cycles are over and the economy can grow indefinitely which attributed to an unchecked expansion. The key point here is that economic recessions are and have been a part of economic system hence this current economic recession cannot be called a failure or collapse of capitalism. Rather it is a part of the system itself. Indeed this is not the first recession in the world and just some recent examples which should not be in distant memory are the recession of 2001, Russian debt crisis, Asian crisis, Mexican and Latin American crisis and the recession of 1970s. Economic depression is not an outcome of bad economic policy.
The global economy had a hard landing because of lack of risk management
The economic recession has been sharp because of financial leverage. Leverage works in a wonderful way to amplify profits in an expansionary environment but similarly exacerbates losses during recessions. The last five years have been one of longest periods of low interest rates. Easy availability of credit and low rates of interests, especially in the developed economies led to a sharp rise in both individual and corporate debt levels. Real interest rates in most of the world were either near zero or in the negative range. Since the opportunity cost of capital was low, risky investments which would not have been profitable in other scenarios became NPV positive and attracted investments. Similarly speculation and investments in assets classes like real estate, frontier markets and in ETF of oil and commodities also became an attractive investment. New financial products like ABS and CDO have been blamed to be the cause of the credit crunch. However, I believe that these products were only invented to fulfil the demand from investors, who were looking for yield enhancing assets. The cause of the problem was not the products but rather the investment and risk measurement methodologies which made them attractive. Most investment valuation models are based on NPV or similar discounted value techniques which rely on discount rate or the cost of capital as the key input. At the prevailing interest rates at those times, most investment projects became NPV positive and hence value enhancing. Similarly, most risk models are based on VAR which measures the value at risk at 95% confidence intervals. These models rely on historical data and since financial crisis are 2 standard deviation plus event, these models failed to capture them. Nassim Taleb’s best seller book Black Swan examines this point in great detail. Also diversification of risk by investment in uncorrelated assets is still a standard technique used in portfolio management. However, as we know from previous experiences as well, that during financial crisis, all assets classes decline in tandem and the correlations approach 1. Indeed the failure of hedge fund LTCM in the late 90s was attributed to this fact (Roger Lowenstein, When Genius Failed).
Deterioration in credit quality was expected and some defaults were also very likely in a recessionary environment. Similarly defaults in sub-prime market were also not extra-ordinary. The real problem rose because risk management and even risk quantification became difficult. Banks and other investors were not able to ascertain how much exposure they had to toxic assets and how much had the diversified away through derivative products. Similarly, the regulators had limited capacity and capability to measure the risks in the system. Especially since the global financial system had become integrated, a single regulator had very limited insight.
Conclusion: don’t blame the system
I have argued in this analysis that the problem lies not in the capitalist system but rather in our understanding of business cycles and consequently of depression economics. Unfortunately the policy response has been more of a witch hunt of bankers, hedge funds and of the capitalists system. Congressional hearings have focused on bank bonuses and private planes of the bank executives. According to a recent article in Financial Times by a Rabbi, even Jews have been blamed for the financial turmoil.
A critique of capitalism cannot be based on economic recession, however, recessions and depressions seem to be the only times when the system is criticised. During economic expansions laurels are heaped on the economic system. This is exactly why the words of Roosevelt which I quoted in the start, remained buried since the 1920s. I believe that a re-examination and critique of the capitalists system only based on its success cannot be substantial and long lasting. Questions of morality, ethics and responsibility of the economic system should be separate from its efficiency rationale. However, since these questions are often raised when the system is in a recession, they get negated as soon as the economy gets out of the recession. Hence, I believe till current critique of the system will also not last long.
The global economy has changed over the last decade. The financial crisis is a proof of the degree of integration in the system, especially in the banking system. In order to deal with this new global economic system, the US alone cannot play the role of the anchor regulator. I think the way forward would require a beefing up of IMF as a global coordinator of economic policy as well as a financial supervisor. Similarly, risk assessment methods need to be adapted to new reality. This would require updating and disseminating new financial research as well as capacity building.