Not a Crisis of Capitalism but one of Finance and Ethics

Capitalism is an economic system based on a free market, open competition, profit motive and private ownership of the means of production. Capitalism encourages private investment and business, compared to a government-controlled economy. Investors in these private companies as i.e. shareholders also own the firms and are known as capitalists.

Capitalism as a system developed incrementally from the 16th century in Europe and England, although some features of capitalist organization existed in the ancient world and early aspects of merchant capitalism flourished during the late middle ages. Capitalism has been dominant in the western world. Capitalism gradually spread throughout Europe, and in the 19th and 20th centuries, it provided the main means of industrialization throughout much of the world.
Economists usually put emphasis on the market mechanism, the degree of government control over markets laissez fair and property rights.

However to improve the present crisis situation there still is a long road ahead before this financial crisis is resolved. There will be many more bankruptcies. Banks will have to slowly earn their way out of their problems or die. Consumers will save more before they start spending again. Mountains of debt will have to be reduced. Capitalism is being rebalanced, reregulated and thus restored. In doing so it will have to face up to long-neglected problems, if this is to lead to a true recovery, not just a brief reprieve.

A few years from now, strange as it may sound, the world might discover that more capitalism, not less is required. An economic crisis slows growth, and when countries need growth, they turn to markets.

If, in the years ahead, the consumer remains reluctant to spend, if federal and state governments groan under their debt loads, if government-owned companies remain expensive burdens, then private-sector activity will become the only path to create jobs. The simple truth is that with all its flaws, capitalism remains the most productive economic engine that ever has been invented.

Capitalism means growth, but also instability. The system is dynamic and inherently prone to crashes that cause great damage along the way. For about 90 years, authorities have been trying to regulate the system to stabilize it while still preserving its energy. Now it maybe at the start of another set of these efforts. In undertaking them, it is important to keep in mind what exactly went wrong. What has been experienced is not a crisis of capitalism it is a crisis of finance, of democracy, of globalization and ultimately of ethics.

Finance screwed up, or to be more precise, financiers did. In June 2007, when the financial crisis began, Coca-Cola, PepsiCo, Nestle, Unilever, Procter & Gamble, IBM, Exxon, Royal Dutch, Nike, Wal-Mart and Microsoft were all running their companies with strong balance sheets and sensible business models. Major corporations were highly profitable, and they were spending prudently, holding on to cash to build a cushion for a downturn. For that reason, many of them have been able to weather the storm remarkably well. Finance and anything finance-related—like real estate—is an entirely different story.

Finance has a history of messing up, from the Dutch tulip bubble in 1637 to now. The proximate causes of these busts have been varied, but follow a strikingly similar path. In calm times, political stability, economic growth and technological innovation all encourage an atmosphere of easy money and new forms of credit. Cheap credit causes greed, miscalculation and eventually ruin.
Banks that are too large to fail should also be too large be leveraged at 30 to 1. Or worse 50 to 1 as in Europe is the case. The incentives for executives within banks are skewed toward reckless risk-taking with other people's money. The huge bonuses are proving it.

The simplest safeguard regulators have had, of course, is the interest rate on credit. In responding to almost every crisis in the past 15 years, former Fed chairman Alan Greenspan always had the same solution: cut rates and ease up on money.

Greenspan behaved like most American political leaders over the past two decades—he chose the easy way out of a hard situation. William McChesney Martin, the great Fed chairman of the 1950s and 1960s, once said that his job was to take the punch bowl away just as the party had begun. No one wants to do that in America anymore—not today’s Fed chairman Ben Bernanke nor the Obama team, and also not the regulators, not Congress or anybody else in charge.

Government actions should be "countercyclical"—that is, they should work to slow down growth. So, in boom times, the Fed would raise rates and require banks to have higher capital and lower leverage.

Fannie Mae and Freddie Mac should have worried about too much easy credit, and have raised standards for loans and disqualify buyers unlikely to be able to afford houses. Banks would be urged to slow down the supply of credit cards and other credit instruments.

Since Ronald Reagan's presidency, Americans have consumed more than was produced and have made up the difference by borrowing. This is true of individuals but, far more dangerously, of governments at every level. Government debt in America, especially when entitlements and state pension commitments are included, is terrifying. And yet no one has tried seriously to close the gap, which can be done only by either raising taxes or cutting expenditures.

This is the disease of modern democracy: the system cannot impose any short-term pain for long-term gain. For 20 years, most serious structural problems—Social Security, health care, immigration—have been kicked down the road. And while the problem is acute in America, Europe and Japan many face the same difficulties.

Then there is the end of inflation. In the 1970s, dozens of countries suffered hyperinflation, which destroyed the middle class, destabilized societies and led to political upheaval. Since then, central banks have become very good at taming the monster, and by 2007 the number of countries with high inflation had dwindled to a handful. Only Zimbabwe has hyperinflation.

Good times always make people complacent. As the cost of capital sank over the past few years because of interest rates were too low for too long, people became increasingly foolish. The world economy had become very much more complicated, so complicated that nobody was able to understand what was going on anymore. So finally the system crashed.

The failure of self-regulation over the past 20 years—in investment banking, accounting, rating agencies—has led inevitably to the rise of greater government regulation. Perhaps the state should not set the pay of the private sector. But surely CEOs should exercise some judgment about their own compensation, and tie it far more closely to the long-term health and profit of the company.

The world is in the midst of a vast crisis, and there is enough blame to go around and many fixes to make, from the international system to national governments to private firms. But truly there is need for a deeper fix within all of us, by applying a simple mental check, whether it feels right, to doing it, if not don’t do it. That's not going to restore growth or mend globalization or save capitalism, but it might be a small start to sanity, and find from there on innovative ways to improve the economy and doing it differently.