Capitalism:
another big transformation is upon us
ICCBE
July 2013
Han de Jong
ABN AMRO Bank NV
“While competition is essential to economic progress, I can’t say I always
personally enjoy the process”
Alan Greenspan
1
Summary
No other system in history has been able to raise material living conditions for so many people as much as
capitalism has done. Having said that, capitalism is a system that contains a constant potential for conflict:
conflict between the market and the state; between the group and the individual; and between 'winners' and
'losers' in the market process. The market mechanism is undoubtedly a very efficient allocation mechanism.
There are, however, two major problems associated with it. First, the market sometimes fails. And second,
the market sometimes provides results that are not acceptable, either for social, political, or other reasons. It
is the role of the state to make sure markets can function properly and to take corrective action when they fail
or produce unacceptable results. At times, the various conflicts cannot be resolved in a satisfactory manner
and the system becomes seriously imbalanced.
Capitalism is an adaptive system that evolves over time. When a serious imbalance occurs, the system can go
through a major transformation. After the depression of the 1930s such a transformation took place. The role
of the state was increased, macro stabilisation policies became commonplace, workers' rights were
strengthened and income distribution became more equitable, partly through the tax system. After some time,
however, another crisis hit - the stagflation of the 1970s. The post-war economic system was unable to cope
with the challenges it faced and so another big transformation occurred. The Thatcher-Reagan revolution
reduced the power of unions and tried to increase the growth potential of the economy by liberalisation,
deregulation and more emphasis on market forces. This system gradually evolved into neo-liberalism.
Confidence in markets increased at the expense of appreciation for the public sector, and markets were given
more and more room to develop. Paradoxically, the public sector did not get much smaller during this period.
At the micro level, the aim of companies was narrowed down to creating shareholder value. The crisis of the
last couple of years has revealed that the neo-liberal form of capitalism has run into problems. People feel
disillusioned with 'the market'. Inequality has risen in many countries to a level that leads to social
disengagement. Excesses in the financial sector have undermined confidence in financial institutions. The
crisis in the financial sector is a symptom of the crisis of neo-liberalism. Enormous challenges lie ahead,
ageing, health care, environment, energy, food (safety), water. Neo-liberal capitalism is unlikely to find
answers to all these challenges. Another fundamental transformation of capitalism is upon us. Governments
and the market must find each other again as partners, as natural complements of a vibrant capitalism, not
enemies. Government must re-define its role. It can and must play a greater role in fostering economic
growth. It must recalibrate the incentive structure of the welfare system. Yet, given its size, government must
get smaller, not larger. The market must broaden its horizon. The lopsided focus on shareholder value is a
thing of the past. If government and the market are to be each other’s partners, the market must take on
increasing social responsibilities.
Capitalism is resilient, it will survive. Any transformation is difficult and the period ahead promises to be
challenging and confusing. Established interest will, unsuccessfully, defend the status quo. It would be more
constructive to embrace the necessary change. A number of changes that we need have been set in motion. I
am confident that we will succeed.
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Introduction
When the credit bubble burst in 2007/2008 and it became obvious that the world economy was at serious
risk, I re-read literature I had studied in the past about financial crises, from Kindleberger to Minsky. I also
thought about what I remembered other economists had written, from Marx to Von Mises, Hayek, Keynes
and Schumpeter. This refreshed knowledge gave me confidence about analysing and predicting how things
might evolve. However, I was completely caught out by two aspects of the crisis. First, I did not at all,
perhaps naively, anticipate the complete collapse of confidence in and respect for banks (and bank
employees, for that matter). The second thing I failed to anticipate fully was the diverse nature of people's
assessment of the causes of and solutions for the crisis. For example, one acquaintance argued that the crisis
would inevitably lead to a significant dismantling of the welfare state and to much smaller government.
Others argued the opposite, that we need much more government. In their view, the crisis shows that the
market economy has failed. In this paper I want to explore the question whether or not and to what extent
and in what direction the crisis is likely to change our capitalist economic system.
Even after preparing for this paper I still have many questions, some of which are almost too politically
incorrect for a bank employee to raise at this point in time. One of the more pertinent ones, is why my two
best friends, one of them a lawyer working for the Dutch government, the other (also working in the public
sector) a geographer who became an IT specialist and then moved into HR, are so surprised and indignant
that we got hit by this financial crisis. Their approach to the current crisis is: "let's find the culprits (’and we
have a good idea who that might be’), lock them up, throw away the keys, problem solved". They seem to
think that we have a basic right to live our lives without financial crises. When I consider the financial
developments during my working life so far, I see little justification for such an expectation. When I joined
the financial services industry in 1984, the Latin American debt crisis had just started two years earlier and
the number of countries in crisis was still rising. Before too long half the Savings and Loan banks in the US
went bust. Then, the huge Japanese property and equity bubbles burst, starting in 1990. The early '90s were
characterised by a recession triggered by the rise of the oil price following the first Gulf War and the
aftermath of the overheating related to German reunification. At the same time, several Nordic countries in
Europe experienced a significant banking crisis. The ERM crisis hit in 1992/1993. The sharp devaluation of
the Mexican peso in December 1994 triggered the Tequila crisis. The Asian crisis then erupted in 1997,
triggering several other problems as well, such as the rouble crisis in 1998. The internet bubble burst in 2000
and the peso crisis in Argentina and that country's default followed quickly in 2001. This list is not
exhaustive. Over this twenty-year period there have been many smaller, local financial crises as well. In any
event, it is fair to say that the twenty years starting in 1982 were littered with financial shocks and crises,
many of which had serious international dimensions. Is it devious irony that economists refer to this period
as the "Great Moderation"1? Of course, the theory of the Great Moderation does not look specifically at
financial shocks but at overall macroeconomic volatility in a number of key economies. Suffice it to say that
my best friends, who are so shocked by the current financial crisis, seem to have felt and based their
expectations on the effects of the Great Moderation but appear to have been completely oblivious to the large
number of crises over the last thirty years. Admitted, most of these crises had relatively little impact on their
own comfort zones.
1
The term the Great Moderation was introduced in James Stock and Mark Watson (2002), but was popularised by Ben Bernanke in a speech in
February 2004.
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Thinking about capitalism2
I am well aware that my readers are familiar with the writings of past philosophers, moralists and economic
thinkers. Nonetheless, it might be no harm for us to recall some of their ideas, particularly regarding
economic systems. I have grouped thinkers before Adam Smith in box 1, below, which may make it easier to
decide to skip that part.
When reviewing what philosophers, political scientists and economists have said about capitalism through
the ages, I am struck by three things. First, today's discussions about our economic system resemble to some
extent discussions from the past. It is therefore interesting to listen to history. Second, economic thinkers
usually respond to thinkers before them with whom they do not agree. They subsequently often go to an
extreme, provoking others to form a new school of thought. Third, economic thinkers do not usually 'lead'
but, instead, 'follow' and respond to changes in economic reality.
Before reviewing what thinkers in the past have said about capitalism, we need a definition. There are many
definitions possible and capitalism comes in many shapes and forms. But it is probably fair to say that
capitalism is an economic system that is characterised by private property, by the exchange among legally
free individuals, while production and distribution are directed by a market mechanism. Ambition, initiative,
individualism and competitive spirit are key ingredients.
The coexistence of the market economy and the state is a source of potential tension, as is the tension
between the interest of the individual versus the interest of the group. Conflicting interests of different
groups in a market economy can also lead to tension as a competitive process can have winners and losers.
From time to time tension builds to such an extent that a process of significant change is triggered.
Capitalism is an adaptable system that has evolved over time.
Box 1. A very brief history of thinking about commerce, markets and capitalism before Adam Smith.
Although they were economically successful, the Greeks and the Romans distrusted commerce. Aristotle, for
example, felt that the pursuit of money had no natural end to it. In fact, he believed that it tends to lead to
excesses (sounds familiar?), in contrast to agriculture. For the Greeks and the Romans the highest that
humans could aim for were civic virtues, in particular fighting for the republic and governing. Through the
Middle Ages the Christians were also hostile to commerce as they considered the pursuit of riches a threat to
salvation. The biblical basis for this is not hard to find. "It is easier for a camel to go through the eye of a
needle than for a rich man to enter the kingdom of God" is a phrase that can be found in three Gospels
(Matthew, Mark and Luke).
An increase in agricultural production in the 13th century led to a minor commercial revolution and the
church changed its tone a little. It tolerated and perhaps encouraged the formation of professional
associations - guilds. Any concept of social mobility remained absent, however. One should only aspire to
one's fair share, one's traditional share. It really wasn't until the 17th century that economic and political
thinking changed dramatically. Thomas Hobbes (1588-1679) argued that government should not decide for
the people what the higher purpose in life is, be it either civic virtues or salvation. Peace, prosperity and
intellectual development were his ideal. Self-interest as a legitimate driver of human behaviour comes
2
This section draws heavily on Jerry Muller (2008).
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through in his work. Enabling worldly happiness should be the purpose of government. Hobbes set the stage
for John Locke (1632-1704), the father of liberalism, who believed that the role of the state should be to
protect its citizens and allow them to pursue the goals they consider the highest.
The 17th century was the time of Dutch economic power. The Dutch East India Company was the first
enterprise in the world to issue shares (1602), which were traded on the first stock exchange in the world. It
was probably no coincidence that the economically most successful country in Europe was also the most
tolerant religiously. Amsterdam was a multi-cultural, multi-lingual city. Holland's success led European
thinkers to reconsider their civic-republican and Christian traditions and adopt a more commercial
dimension. The interaction between commerce and national power was characteristic for the Dutch Republic.
The phrase 'political economy' was born (in France, 1615).
The 18th century was the age of the Enlightenment. Printing techniques had evolved from their 15th century
invention to allow the large scale production and distribution of books. This led to the increasing importance
of 'public opinion'. Voltaire (1694-1778) stressed the legitimacy of material consumption. In addition, he
recognised that the pursuit of wealth through market activity could have important political benefits. A
financial revolution played out. The Bank of England was founded in 1694, tax collection became common
and a market for state debt emerged. The public, however, responded with suspicion. People trading on the
London Stock Exchange were often referred to as 'gamblers, money grabbers and speculators'. It would seem
that 'speculators' have survived and are still alive and kicking as a popular, multi-purpose culprit.
Moralists objected to the pursuit of individual well-being as this pursuit was considered to be at the expense
of the common good. Rousseau (1712-1778) developed a critique of the evolving 'commercial society',
which, he believed, was leading to a corruption of morals. The rise in living standards was leading to new
desires, distracting people from moral purposes. Private property was evil as it leads to inequality and thus is
a source of misery. The common interest must be given a higher priority, according to Rousseau, than
individual interests. Voltaire and Hume responded to Rousseau wondering if Rousseau's obsession with
equality wasn't a recipe for collective poverty. This 18th century discussion is as relevant today as it was
then.
Adam Smith (1723-1790) is usually seen as the founding father of theoretical capitalism, or as the advocate
of free markets. The goal of the market economy, in his view, is the ongoing rise in the standard of living of
the vast majority of the population. He analysed how a system in which people are mainly driven by selfinterest provides good results in this respect. This view can hardly be captured better than in his own words:
" It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from
their regard to their own interest". That said, Smith realised that people have other drivers beside selfinterest, as he eloquently phrased in the first sentence of his Theory of Moral Sentiments: "How selfish
soever man may be supposed, there are evidently some principles in his nature, which interest him in the
fortune of others, and render their happiness necessary to him, though he derives nothing from it except the
pleasure of seeing it."
In contrast to what is sometimes argued, Smith did not advocate a blind faith in markets. He showed that the
pursuit of self-interest does not automatically and universally lead to the public benefit. Markets need to be
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structured and regulated. Smith saw that the outcome of a market process could be suboptimal or simply not
acceptable if certain participants had a disproportionate amount of power on the market. He favoured a wellfunctioning government that would provide what the market couldn't and that would make sure that markets
functioned optimally. The government was responsible for, among other things, infrastructure and education.
The state also had to protect property rights. As the rich benefit more from that than the poor, Smith found it
reasonable that the rich should pay more tax. He also saw the potential tensions in a market economy: "...the
affluence of the rich excites the indignation of the poor".
Subsequent thinkers focussed on the position of the individual in the commercial society. Others
concentrated more on the question how to make capitalism better, more productive. The US's first Treasury
Secretary, Alexander Hamilton (1755-1804) stressed the need for a strong national government. His
Federalist Papers, a blueprint for the growth strategy of the young United States, contained many elements
seen in the growth strategy of many emerging economies nowadays. There was a clearly defined role for
government in Hamilton’s economic plans, ranging from protecting domestic sectors to playing an active
role in the development of certain sectors.
Capitalism’s first big transformation
The industrial revolution led to significant economic growth, but also to hardship among the working class.
The circumstances under which many people had to work were appalling and the work they were doing
could hardly have given them any intellectual or other satisfaction. It is no surprise that this led to criticism.
Karl Marx believed that capitalism was full of inconsistencies and would end in crisis. This would trigger a
revolutionary change, paving the way for a classless society. Just to make sure, he formulated two crisis
theories. Capitalism would go down because of a lack of demand due to an extremely unequal distribution of
income and as a consequence of a falling profit rate. Marx did, however, recognise the great achievements of
capitalism. He recognised its dynamism and the significant growth it had brought.
But Marx was proven wrong on the inevitability of revolution. Capitalism doesn't break, it bends. Contrary
to what Marx believed, workers' wages did not fall to subsistence level, but started to climb while working
conditions improved. And the lack of demand Marx expected, proved not chronic but incidental.
Nevertheless, as we know, 'professional revolutionaries' established a communist regime in Russia, and other
countries followed. The communist regimes were characterised by a lack of economic freedom and a lack of
political freedom, but a certain degree of material security, often after an initial period of chaos.
Western thinkers such as Hayek, Schumpeter and Von Mises later made the connection between capitalism
and freedom, or democracy, or rather between socialism and lack of freedom. It was clear, though, that
capitalism also had negative consequences and it needed to change. It needed to adapt to the growing wish
for economic security and stability in people's lives and respond to the threat of socialism which seemed to
provide for greater security and fairness. This response consisted of several elements. Workers’ rights were
strengthened, redistributive taxes were introduced, the development of a social safety net started and
government spending was raised. Keynes provided the theoretical backing for macroeconomic stabilisation
policies.
This new phase of capitalism was successful, particularly after World War II, in terms of generating
economic growth and providing stability. Sadly, this period of solid growth, full employment, increasing
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workers’ rights etc. ended in stagflation in the 1970s. The Vietnam war caused significant financial stress on
the US government as did the growing social programmes, which also increased significantly in Europe.
Monetary policy was accommodative. At the same time trade unions became increasingly self-confident and
militant. Perhaps one can argue that this phase of capitalism became the victim of its own success. The
success of economic policies implied high, sustained employment numbers and steadily rising real income
levels. No wonder that workers became more self-confident. This is perhaps the ‘real economy’s equivalent’
of Hyman Minsky’s financial instability hypothesis3. The oil price shock of the early 1970s pushed up
inflation further, sealing the fate of this period of capitalism.
The second big transformation of capitalism
Adverse economic conditions forced capitalism to adapt again and it did. Following the (in)famous winter of
discontent in the UK, Margaret Thatcher won the 1979 general elections and Ronald Reagan was elected
President of the US a year later. They steered the capitalist system in a different direction, giving the market
a much more dominant position at the expense of government and unions. Perhaps one could also say that
‘capital’ was rehabilitated relative to ‘labour’. Milton Friedman (and other economists, of course) provided
the theoretical economic foundation.
Even now it is hard to say with certainty what exactly explained the success of the Reagan-Thatcher era. Paul
Volcker’s Fed killed inflation quickly, though at the expense of a deep recession and high unemployment.
This certainly put paid to over-confidence on the part of workers and unions. Interestingly, despite the
rhetoric, the Fed moved away from its extreme-monetarist policies relatively quickly. Volcker suspended
money targets in August 1982. Officially, the Fed’s road to success continued to be based on maintaining
price stability. In reality, however, economic policy moved back to a more subtle version of demand
management. Monetary policy took over some of the responsibilities of fiscal policy in this respect. The
rhetoric in Europe was more pertinent and to this day the ECB's mandate consists of price stability only (and
financial stability). However, the actions of the ECB and its effective predecessor, the Bundesbank, show
that monetary policy in Europe was also much more pragmatic than officially professed and served demand
management at times.4
Deregulation and supply-side improvements undoubtedly contributed importantly to improving growth. But
the victory against inflation, the gain in confidence and stability and the drop in borrowing costs that implied
were arguably the decisive factors.
Neo-liberalism and the crisis
The fundamental elements of this new phase of capitalism were nicely summarised by John Williamson in
the 'Washington Consensus' he formulated in 1989.5 From here the system gradually developed into neoliberalism, which is characterised by a distrust of government intervention in markets and an extreme faith in
3
Minsky argued that a period of financial stability lures borrowers into a false sense of security. They then overborrow, which eventually leads to
financial instability. Thus, in Minsky’s view, a period of stability will almost certainly ultimately lead to instability.
4
The traumatic hyperinflation of the 1920s in Germany is often seen as reason for the big fear among the German public for anypolicies that could be
inflationary. Sometimes one wonders if this hyperinflation trauma can only be overcome if Germanygoes through an equally traumatic phase of
deflation. I hope not.
5
The ten elements of the Washington consensus were the standard measures that the IMF prescribed to countries that had got themselves in trouble:
fiscal discipline; cut subsidies; tax reform; positive real interest rates; competitive exchange rates; trade liberalisation; free FDIs, privatisation of state
companies; deregulation; protecting property rights.
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free, laissez faire markets. "The market knows best". Former Fed chairman Alan Greenspan was perhaps the
personification of this. He was a strong believer in the free market - the freer, the better. Competition drives
progress. Greenspan did acknowledge that the process of competition isn't always pleasant, which he
succinctly expressed in his autobiography: "While competition is essential to economic progress, I can't say I
always personally enjoy the process. I never thought kindly of rival firms seeking to lure clients from
Townsend-Greenspan. But to compete, I had to improve. I had to offer a better service. I had to become more
productive. In the end, of course, I was better off for it".6 Greenspan was a follower of Ayn Rand (19051982), the best-selling Russian/American novelist and philosopher, whose philosophy caught on in the US
but not very much in Europe. Rand grew up in Russia, but moved to the US in 1926. She developed a
philosophy which she called 'objectivism' and which sees the pursuit of one's own happiness as the proper
moral purpose in life. Her dislike of anything related to collectivism is surely a reaction to her experience in
Russia after the revolution of 1917. Her extreme views were clearly a brigde too far for most Europeans.
Greenspan's faith in markets defined his approach to central banking. In the area of regulation, he favoured
'regulation-light'. Other contemporary policymakers held similar beliefs, and a period of financial
liberalisation took place from the early 1990s on.7 Greenspan was convinced that supervisors could not keep
up with developments in financial institutions and would therefore always be behind the curve. He felt that it
was OK to rely heavily on the self-interest of senior management in banks. But before a Congressional
committee in October 2008, Greenspan said: "I made a mistake in presuming that the self-interests of
organisations, specifically banks and others, were such that they were best capable of protecting their own
shareholders and their equity in the firms. Those of us who have looked to the self-interest of lending
institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief."
Contrary to what Greenspan had assumed, banks' management did not pursue the interests of all
stakeholders. At the company level, neo-liberalism is characterised by an increasing focus on shareholder
value. The idea is that maximising shareholder value provides the best results for everybody. It has become
clear, however, that the interests of all stakeholders were not sufficiently aligned to achieve this.
Greenspan had also developed a libertarian, hands-off approach as far as alleged bubbles on financial
markets were concerned. He had been convinced that central bankers could not know better than market
participants what the right valuation of assets is. In addition, from experience he had concluded that it was
difficult, if not impossible for the Fed to let air out of a building bubble. Greenspan believed that instead of
trying to identify a bubble and deflating it, the central bank should limit itself to 'cleaning up' if and when a
bubble burst.
The Great Moderation, the period of less macroeconomic volatility in a number of key economies, implied
increased stability and thus less risk. Against this background, it was therefore completely logical and
rational that overall borrowing in these countries should increase. It was reasonable and rational for
policymakers to tolerate this. Financial innovation played a role as well. An increasing number of people and
companies gained access to instruments that allowed them to manage their finances better. After the US
6
Greenspan, 2007, p. 268.
I am old enough to remember capital controls in Europe. When asked in 2011 in internal meetings in the bank what could happen if Greece were to
leave the euro, one of the elements of my answer was that Greece would likely impose capital controls. Most of my younger colleagues stared at me
wondering what I was talking about.
7
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housing market crashed and people ended up with negative equity, the financial sector was criticised for
allowing people to use their home as a virtual ATM. That is not entirely fair. A home is an illiquid asset.
Finance had turned it into a more liquid asset. Surely that must enable us to improve economic efficiency,
though clearly not without risk.
Admitted, it is virtually impossible to calculate what an optimal level of total gross indebtedness is in the
economy as a whole. So the authorities could not know whether or not too much debt was being created.
What one can say, though, is that the combination of increased stability, and thus lower risk, and Greenspan's
(and other policymakers as well, of course) neo-liberal views contributed to the build-up of debt that
financed the housing bubble.
Europe, meanwhile, was building its own ‘bubble’. The arrival of the euro was followed by a strong rise in
capital flows between eurozone members. Investors in core countries were searching for yield in peripheral
countries. The inflow of capital was welcome for the recipients as it pushed borrowing costs lower and
provided funding for growth. Unfortunately, the funds were often used for consumption and for driving up
the property sector - not a sustainable basis for growth. The credit bubble burst in 2007/2008. In the US, the
bubble was concentrated in sub-prime mortgages. In Europe in sovereign debt.
Box 2: Bubbles
Economic literature about economic bubbles and their bursting is rich and usually makes for fascinating
reading. What strikes me about such literature is that it tends to focus strongly on the build-up of the bubble
and then its demise, typically neatly dividing the process into separate phases. So the focus tends to be on the
mechanics of the process. Surprisingly little is written about the role of bubbles in our economies. I would
argue that bubbles provide a lot of dynamism to our economies. I see them as more positive than many think,
unless they become too numerous and too large in which case the bursting of one or more bubbles causes a
lot of pain. Standard literature is, as far as I am aware, also a little short on how a bubble affects the bigger
development of which it tends to be a part. In 1637, the tulip bubble in Holland burst. Arguably, the tulip
bubble represented a desire to own Dutch assets as Holland developed into a major power. The bursting of
the bubble did not end that process. Quite the opposite - Holland’s power continued to rise for decades. The
same happened to the South Sea bubble, which can perhaps be seen as the more sensible version of the
Dutch tulip bubble. Buying shares in the South Sea Company was perhaps a proxy for buying a share in the
likely rise of the British empire. The share price collapsed in 1720. That was not the end of British
hegemony. In fact that was still the early stages of rising British power. More recently, the internet bubble
burst in 2000. That was soon after the general public had started using the internet in the course of the 1990s.
The collapse of the Nasdaq did clearly not end the internet era. On the contrary, the bursting of the equity
bubble happened at an early stage in the development of the internet. The most logical explanation for the
course of events in these examples is that markets find it very difficult to assess the value of new assets and
they sometimes get over-excited. However, there usually is an rational or at least understandable element to
the early stages of the building of a bubble, despite accusations of euphoria. In the case of the internet, the
general perception was that it would lift future economic growth. The stock market reflects the present value
of corporate profits. If we ‘suddenly’ decide that future economic growth will be higher than we thought
until that moment, which was the case towards the end of the 1990s, and we assume that corporate profits
will also be higher, it then makes sense for the stock market to adjust sharply as the present value of profits
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has ‘suddenly’ risen. The logical and rational rise in equity prices is then seen as evidence that the new line
of thinking is correct and rising equity prices become self-sustaining. Well, for a while. The point in relation
to the credit bubble is that the bursting of the bubble need not be the end to the further sophistication of the
offering of financial services.
Still confused at two levels about the causes of the crisis
There is broad consensus that excessive risk taking in the financial sector led to the crisis and that tighter
capital and liquidity supervision are an important part of building a more stable system. I have no issues with
that. But there is also a more macroeconomic aspect to the causes of the crisis. Persistent, large and growing
international payment imbalances were an important feature of the global economy after the turn of the
century. Asian countries in particular decided that they needed to build up reserves to prevent a repeat of the
Asia crisis. In order to build up reserves they needed to run surpluses on their balance of payments. This
implied that other countries had to run deficits, with the US volunteering to be champion. For the US to run
external deficits it needed a steady net inflow of capital. As a large part of this capital inflow necessarily had
to take the form of debt, some sectors in the US simply had to raise their indebtedness. So the strategy of
some nations to build up reserves and the increasing indebtedness of some sectors of the US economy are
two sides of the same coin. The reason I am writing this is that I am still wondering if you can somehow
address one side of the coin and not the other. What would happen in a world in which large international
payment imbalances persist but liquidity and capital ratios in banks are raised? Would that prevent persistent
imbalances? And would it prevent the situation exploding or would it make the ultimate explosion only even
more devastating? The truth is that I do not know. What I do know, however, is that one-sided focus on the
robustness of financial institutions addresses only part of the problem. At least for now, this isn't really an
urgent issue. Payment imbalances have been sharply reduced as some deficit countries have experienced
recession and competitiveness in deficit countries has improved through movement of the real effective
exchange rate. But these imbalances can easily come back. Or can they?
What also still confuses me about the crisis, and this will bring me back to the original focus of this paper, is
how the bursting of the US housing bubble almost brought the global financial system down. My assertion is
that the extreme neo-liberal views of the main policymakers in the US are key. Sure, the US housing market
was overvalued, but a cumulative correction from the absolute peak of some 30% over a period of four to
five years isn't really that dramatic. There are probably two explanations why the bursting of the housing
bubble had such a disproportionately large impact on the global financial system, both related not only to
irresponsible banking practices but also to the neo-liberal view of the policymakers. Financial deregulation
created room for the build-up of significant leverage in the system, which the central banks tolerated. The
result was that many financial connections became linked to the US housing market. Shortly before the crisis
erupted, Greenspan wrote: "I was aware that the loosening of mortgage credit terms for subprime borrowers
increased financial risk and that subsidized homeownership initiatives distort market outcomes. But I
believed then, as now, that the benefits of broadened homeownership are worth the risk."8
The second factor was the policy response. If you accept that market economies are prone to boom-bust
cycles and that policymakers are responsible for maintaining stability, you will agree that policymakers must
intervene when oscillations go out of control. In such circumstances, government intervention is not a
8
Greenspan, 2007, p. 233.
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favour, it is an essential element of government.9 Our financial system, including our money, is based on
confidence. Confidence can disappear, be it for rational or seemingly irrational reasons. The government is
the provider of confidence of last resort. It really is that simple. That, of course, does not excuse financial
institutions for taking irresponsible positions. But when it came to 2008 those positions had been taken and it
was up to policymakers to ensure that confidence was maintained. Several major mistakes were made - with
very negative consequences.
Previous crises had taught some important lessons that were ignored in the recent turmoil. Since Milton
Friedman and Anna Schwartz wrote their seminal work on the monetary history of the US in the 1960s,
experts had agreed that letting many banks collapse was a significant policy mistake in the 1930s that
contributed to turning a recession into a depression. One cannot argue that many relevant banks failed this
time around, but the way the US government dealt with Fannie Mae and Freddie Mac was not helpful to
maintain confidence to say the least, and letting Lehman fail was clearly a bridge too far. The international
debt crisis of the 1980s had shown that the financial system can cope with such shocks if given time to heal.
The mark-to-market accounting rules introduced much later do not allow for such a strategy. From a
macroeconomic perspective, mark-to-market accounting is a mistake. It amplifies the boom-bust cycle.
During good times, asset values rise giving the possibly false impression of value creation. Capital ratios
look much better on paper than they really are. This encourages further lending and investing by financial
institutions. When bad times arrive, the opposite happens. Capital ratios are suddenly not what they were
thought to be. Banks are forced to tighten credit standards and the down leg in the economic cycle is
reinforced.
Policymakers were to a large degree in uncharted territory and it is perhaps a little unfair to label some policy
decisions as mistakes. Still, I think that the way the US policymakers dealt with the Fannie Mae and Freddie
Mac was a policy mistake. There was deep distrust and dislike within Republican ranks regarding these two
Government Sponsored Enterprises (GSEs). When the (Republican) Treasury Secretary, Hank Paulson, saw
an opportunity to take control of them, he did. The two GSEs were obviously under pressure, but not to the
extent that justified the actions taken by the Treasury Secretary. It is hard to see why he wiped out
shareholders in both organisations. This not only rewarded the 'speculators' who were betting against them, it
also hurt overseas investors who had assumed they would have been covered by an implicit government
guarantee. As we know, this is the big dilemma for policymakers. They have to weigh up the risk of creating
moral hazard against the risk of financial instability and all this against a background of increasingly hostile
public opinion. How much financial instability are policymakers willing to risk in their efforts to fight moral
hazard?
Up until the summer of 2008, things had been progressing in a reasonably orderly fashion. Banks under
pressure successfully sought recapitalisation. Sovereign wealth funds in Asia and the Middle East bought or
increased their interests in US financials. When Bear Stearns got in trouble, it was sold with the support of
the government and the Fed. The winding down of its business happened in relative calm. Bear Stearns was
9
This logical argument can sometimes become very emotive. When discussing the crisis at a meeting with ABN AMRO's executive and supervisory
boards in 2011, I said that policymakers had done a good job in stabilising the situation and that that also was their job. The last part of that
observation triggered an emotional response from one of the members of the supervisory board who found my attitude insufficiently repentant.
Kaletsky phrases it nicely, there still is "unprecedented revulsion against wealth and finance". (Kaletsky, 2010, p. 272.)
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involved in numerous derivative positions with many different counterparties. Unwinding these positions
could have been chaotic, but it wasn't, as confidence in the integrity of the system was maintained.
But the way the GSEs were dealt with in September 2008 had significantly negative effects on confidence.
Lehman Brothers was also under pressure at the time. Negotiations with the Korea Development Bank to
take over Lehman, either alone or as part of a consortium were taking place, but the Koreans suddenly pulled
out after shareholders in Fannie and Freddie were wiped out. Other efforts to find a take-over candidate for
Lehman failed and Lehman filed for bankruptcy on 15 September 2008. Lehman had a balance sheet total of
some USD 600bn, a big bank, but not huge, and it had no retail depositors. According to Bloomberg, the
losses of Lehman amounted to USD 75 bn10. While this is a large amount, it pales into insignificance
compared to the damage done to the world economy resulting from the loss of confidence that followed the
Lehman collapse. And this is the key point: the collapse of Lehman triggered a complete and total loss of
confidence in the global financial system that led to it seizing up in many countries. Ricardo Caballero talks
about a 'sudden financial arrest', an analogy with a sudden cardiac arrest in medicine.11 Soon after, the
government decided to rescue AIG. With hindsight, the assets bought by the US government/Fed from Bear
Stearns and AIG netted a profit, showing that if given time, positions that look unviable during periods of
stress can recover and often do.
Economics and policymaking do not constitute an activity that can be conducted in a sterile lab. It is easy for
me to say that US policymakers made big mistakes, causing a complete loss of confidence, turning the
bursting of the housing bubble from a significant, unpleasant event into something that threatened to lead to
a complete collapse of the global financial system and a depression. It must be said, though, that it is difficult
to determine how the crisis would have panned out had decisions been different. We can only make an
educated guess.
Europe 'doing a Lehman'
European financial institutions and investors had bought securities based on the US housing market and had
ties with US financial institutions. So Europe was affected by what happened in the US. But Europe also had
its own credit bubble. This was (apart from a small number of countries) not so much in housing but in intraeurozone cross-border lending. In the years after the introduction of the euro, considerable amounts of capital
had flown into the 'periphery' in search for yield, triggering large deficits on the balance of payments of
several countries. When US economic woes led to a global recession, the credit risks in Europe became clear
and the financial position of several sovereign borrowers became unsustainable. When the tide went out, all
could see who had been swimming naked (to borrow a Warren Buffett phrase). Bail-out packages were
required to keep the system functioning, along well-established principles of policy adjustment, official
financing and allowing time to adjust and pay back. In 2011, the strategy changed. Until then investors had
assumed that sovereign bonds of a eurozone country were (relatively) safe. But in 2011, holders of Greek
sovereign bonds were asked to exchange their bonds for new ones with a considerable loss in face value as it
became increasingly difficult to explain to the public in other eurozone countries that providing public
support to the Greek government was money well spent. And as such, this approach can be understood. An
investor should take responsibility when thing do not work out. Having said that, the Greek debt write-down
10
11
Kaletsky, 2010, p. 135
Caballero, 2009
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led to significant stress in the financial system in Europe. Spreads of other peripheral countries government
bonds widened significantly as holders of these bonds became unwilling to keep them for fear of losses
either by defaults, voluntary write-downs or break-up of the euro. The damage done to the eurozone
economy was significant.
The business cycle of the European economy has a relatively high correlation with the US business cycle,
with Europe usually lagging the US a little. But in the course of 2011 the correlation broke down completely
as the US maintained growth in 2011 and 2012 of around 2% on average while the eurozone economy sank
into recession in 2011 and has yet to emerge from negative growth. It is unlikely that differences in fiscal
policy alone can explain this divergent performance. According to the OECD data on budget deficits, the
cyclically adjusted budget deficit in the US declined by 1.1% of GDP in 2011 and by 1.3% in 2012. For the
eurozone as a whole the respective numbers were 1.7% and 1.0%. Interestingly, within the eurozone, the
cyclically adjusted deficit shrank the most in Germany - 3.2% of GDP over the two years together. Italy and
in particular Spain reduced their deficits considerably less: Italy by a total of 2%, Spain only 0.3%. Yet Spain
and Italy re-entered recession in 2009, Germany did not. The much more likely explanation for the
breakdown in the correlation between the business cycles in the US and the eurozone, and in particular the
disappointing performance of the peripheral economies is the stress in the financial system in the eurozone,
triggered by the Greek debt problems and especially the Greek debt write-down. The cost of the loss in
output and the rise in unemployment was much larger than what it would have cost to prevent the debt writedown. The political choice not to spend taxpayers' money to bail out investors has ended up costing the tax
payers a great deal more, though they are probably unaware of this. It has been particularly costly to tax
payers in the periphery who lost their jobs. There are two ways of judging this. On the one hand, it could be
described as a significant policy mistake made in an attempt to prevent moral hazard, but primarily because
policymakers were unable or unwilling to explain the mechanics of this process to the electorate.
Alternatively, one can say that this is the price that has to be paid for restoring market discipline and
preventing moral hazard. Take your pick.
Policy mistakes partly driven by neo-liberal ideology
The US government's decisions to wipe out shareholders in Fannie and Freddie and to let Lehman fail, as
well as the decision by eurozone policymakers to force holders of Greek government bonds into a 'voluntary'
debt write-down have significantly increased stress in the financial system, and have thus made the crisis
considerably worse. The question is why these decisions were taken. There are several aspects to this. It can
be argued that an extreme neo-liberal view contributed to the disastrous decisions. Hank Paulson's and a
large part of the Republican party's distrust of the GSEs encouraged them to effectively take control of
Fannie and Freddie. And the view that companies must be allowed to fail in order to maintain the capitalist
spirit was probably behind the decision to let Lehman go bust. A sad comparison between Paulson and
Andrew Mellon, US Treasury Secretary between 1921 and 1932 is hard to avoid. Mellon allowed many
banks to fail, which, as mentioned above, was later seen as a huge policy blunder, turning a recession into a
depression. Mellon had been a successful banker before taking up his position as Treasury Secretary. Hank
Paulson was also a former banker, having been the CEO of Goldman Sachs.12 The decision in Europe to
12
Experience with Mellon and Paulson suggests that successful bankers do not necessarily make good finance ministers. Recent experience in
Holland suggests that it might be easier for a successful finance minister to become a successful bank CEO.
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apply a hair-cut to Greek bonds was mainly driven by public and political outcry against the financial sector.
This was certainly not based by an extreme neo-liberal view.
In both cases a failure to recognise the dangers to financial stability and a failure to appreciate the
government's role as provider of confidence of last resort led to decisions that turned out extremely costly. It
is a pity that policymakers did not manage to find ways to avoid moral hazard while maintaining financial
stability.
Has the free market economy delivered?
Some authors raise the question what economic system produces the best result: the sort of capitalism we had
after WWII, characterised by strong government involvement and explicit attempts to perform cyclestabilising fiscal policy, or the post-Reagan-Thatcher variety with more emphasis on the free market,
ultimately leading to the 'neo-liberal' version of capitalism. I personally do not believe that a definite answer
can be given. Skidelsky13 compares, among other things, the level of economic growth achieved in both
periods. According to the data he uses, the world economy grew at an average rate of 4.8% between 1951
and 1980. From 1989 until 2009 growth amounted to an average of a more modest 3.2%, 'proving' the
superiority of the Keynesian capitalism over the free-market version. Such comparisons make little sense in
my view. One can endlessly argue over the data. Even a mediocre economist can let the data say whatever
you want to hear, provided that he is sufficiently creative and perhaps a little manipulative and devious.
Skidelsky's finding has been more or less contradicted by the IMF, which estimates that global growth
between 1980 and 2012 amounted to 4.5%. More to the point, particular circumstances matter a lot. It is
easier to achieve high growth rates during a catching-up phase than at the frontier of development. With the
right policies in place, emerging economies can achieve much higher growth rates than advanced economies.
The period of strong growth in the western world after WWII was, in fact, also a phase of catching up.
Reconstruction of what had been damaged did not require a lot of innovation, for example. Perhaps it is a
little cynical, but even communist countries managed to grow at a decent rate during the initial post-war
period.
If one looks at what happens with poverty when lesser developed nations get their act together, it is hard not
to conclude that the impact of functioning free markets is huge. According to World Bank data hundreds of
millions of people living in countries with improving market economies have been lifted out of poverty since
the early 1980s. In 'East Asia and the Pacific' the share of the population living in poverty dropped from
77.2% to 14.3% over that period. Progress in South Asia was from 61.1% to 36.0%. The region with the least
progress was sub-Saharan Africa: 51.5% in 1981 against 49.2% in 2008. For the world as a whole, people
living in poverty has dropped from 43% of the total population in 1990 to 21% in 2010. Perhaps more
relevant than the exact version of capitalism for a country's growth performance is the workings of its
institutions as so wonderfully analysed by Acemoglu and Robinson14
While global poverty may have declined during the last three decades, income and wealth distribution have
become more unequal in many countries, though by no means dramatically so in all western economies.
According to The World Top Incomes Database of the Paris School of Economics15, the top 1% of earners in
13
Skidelsky, 2010, p. 185
Acemoglu and Robinson, 2012
15
http://topincomes.g-mond.parisschoolofeconomics.eu/
14
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the US and the UK earned some 18-20% of total income in 1915. In the UK, this share went down to 5% of
total income in 1978 and in the US to some 8%. Following the Reagan-Thatcher revolution the percentages
are back up to 14% in the UK and 18% in the US. Some commentators are now pointing to Karl Marx,
saying that he got it right all along, that capitalism leads to exploitation and poverty. It seems, indeed, that
when left largely to their own devices, markets create unequal outcomes which is acceptable only within a
certain range.
The rise of emerging economies and globalisation has contributed to the more unequal distribution of
incomes in advanced economies. The lower skilled workers in these economies have been increasingly
exposed to unprecedented competition from cheap labour in emerging economies. In addition, several
commentators have described the current economic system as a 'winner-takes-all' system. There can be
several reasons why some markets become 'winner-takes-all'. Technology is an important factor supporting
mega-incomes of superstars in areas such as sports and music. As technology enables a cheap and efficient
worldwide distribution of music and of sports viewing, the top talents are able to tap into previously
inaccessible markets. One example is the popularity of English football in Asia. Likewise, Barcelona
football club increased its total revenue between 2006 and 2012 by 86%, much of that growth coming from
outside Spain (according to data by Deloitte). The astronomical incomes of the super stars, be it in sport or
music, are often frowned upon, but do not appear to generate such resentment that fans switch off.16
Then there are markets where returns to scale do not decrease, but are either constant or increasing. In such
markets, a participant who is ahead of the competition will find it not too challenging to stay ahead and shut
out competition. This is, arguably, the basis for the sustained success of companies such as Microsoft and
Google. As long as they are seen as behaving as reasonably good citizens, their business and incomes are
also tolerated. A number of rulings have been made against some of these companies, particularly by the
European Commission to open up their products and services. Generally speaking, though, in this neo-liberal
era, whether or not companies become too powerful in some areas is only assessed when they take over other
companies, if they are in receipt of government support or if there is a suspicion of illegal cartels or abuse of
power. Very few people argue for the breaking up these large tech companies. This compares to 1911 when
the US Supreme Court ordered the break-up of Standard Oil, which it deemed had become too powerful.
Hard to see that happening nowadays other than in the case of a troubled financial institution.
Last, in some other markets, the power structure allows certain participants to extract economic rent for a
sustained period. This could perhaps be said to apply to finance.17 There is little doubt that average incomes
in finance are higher than in most, if not all other sectors of the economy, though differences vary greatly
between countries. A study by Lawrence Katz found that Harvard graduates working in finance earn three
16
According to Forbes, Tiger Woods was the top-earning athlete in 2012, making USD 78m (EUR 60m) in 2012, USD 65m of which through
endorsements. Also according to Forbes, Aaron Rodgers, a dropout from the University of California, was the athlete who earned most money
directly from his sport, USD 43m (EUR 33m). Rodgers plays American football and my guess is that he is totally unknown outside the US.
According to France Football, Lionel Messi, who was only the number nine on Forbes’ list, earned EUR 13m by playing footballin the 2012-2013
season and topped his total income up to EUR 35m with other activities. Cristiano Ronaldo was paid EUR 13.5m in salary and bonuses by Real
Madrid for a total income of EUR 30m. Top-earning footballer was David Beckham who made EUR 36m, though only 5% of that consisted of
income from playing football (Telegraph Sport, 19 March 2013). Just to compare, Lloyd Blankfein, CEO of Goldman Sachs was allegedly paid a total
package of USD 54m (EUR 42m) in 2010.
17
While writing this part of this paper, I decided to google "why bankers are paid so much?". When I had typed the first two words, Google tried to
help me by suggesting ways for me to finish my query, presumably based on what other people had typed in. The top suggestion was "why bankers
are evil", the third one "why bankers rule the world". Sadly, this is telling of the times we live in.
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times what their former fellow students with the same grade point average earn in other sectors.18 Samuelson
offers an interesting explanation. He argues that people’s earnings are generally linked to the output value of
the organisation they work for. Earnings in finance, he argues, are linked to wealth, because that is what
finance deals with. Total wealth in Western economies is much higher than output. People in finance simply
play for much higher stakes than workers in most other sectors. This is not a judgment, just an observation.
Financial institutions managed to turbo-charge their earnings by building financial leverage into their balance
sheets during the neo-liberal era. While differences between earnings within finance are probably larger than
elsewhere, the very high incomes were gradually cascaded down in financial institutions. More modest pay
packages in finance are required not only from an ethical point of view, they are also an economic necessity
given the process of deleveraging in financial institutions.
Why capitalism will change again
My conclusion is that the market economy produces superior results compared to any other system. Despite
all the evidence, this is sometimes lost on many on the political left. On the other hand, markets will only
give these results if they are functioning properly and embedded in the right framework. Adam Smith knew
that, but somehow it is a point lost on many on the political right. Some commentators argue that the rapid
growth in China shows that our form of democratic capitalism is inferior to their system and that we need to
change to their direction. In response to the Washington Consensus, the 'Beijing Consensus' has been
developed. The Washington Consensus was seen as dogmatic and rigid. The Beijing Consensus consists of
five elements: incremental reform, no big leaps; constant experimentation and innovation; export-led growth;
state capitalism; and authoritarian government. Perhaps I am short-sighted, but I find it difficult to believe
that countries with democratic rule will voluntarily move to an authoritarian model, though I realise that it
has happened before.
I have described above how capitalism has gone through two major transformations in the past: the
Keynesian revolution after the depression of the 1930s and the Reagan-Thatcher revolution from 1980
onwards following the stagflation of the 1970s. The reason for these transformations was that the system had
become unbalanced, negative sides of capitalism had started to dominate. That is not to say that the particular
versions of capitalism had not made their contribution to growth and progress in general. The world
economy has benefited greatly from the Reagan-Thatcher revolution with its emphasis on free markets. Over
time that system moved into an era of neo-liberalism, which also contributed to growth and progress. But this
phase has now come to its end as well. Neo-liberal extremism has led to financial excesses and crisis of a
depth that is not acceptable. The system has created inequality that is threatening social cohesion. Too many
people feel disillusioned, insecure and threatened by the market. Paradoxically, the size of government is
more or less at record levels as a share of the overall economy. Our current mode of capitalism is unlikely in
my view to solve today's problems and provide answers to tomorrow's challenges.
With hindsight, it was easy to see in what direction capitalism needed to change at the time of the previous
two big transformations. The answer to the exploitation of workers was to give them more rights, higher
wages and protection by the government. In the 1980s, we needed more emphasis on the market in order to
increase growth dynamism. This time around, we appear to need both. This will not be easy and we have
18
Samuelson, 2010
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reached a very confusing juncture. Huge financial instability has caused a deep economic crisis. Solving this
crisis hurts and we are in the middle of the process of distributing the pain.
The political right claims that government sectors are too large and need to be reduced in order to increase
economic dynamism. They also claim that an unsustainable number of people in Western societies depend at
least for a part of their income on the state and that governments have made promises to the people that they
will not be able to keep. Despite thirty years of the Reagan-Thatcher revolution, it is asserted that society has
become too soft. The incentive structure has become perverted. The welfare state, meant to be a safety net,
has become a 'lifestyle choice'19. People need to be exposed more to the incentives of the market economy,
take on more individual responsibility. These are valid points.
The political left argues that the market economy has created an unfair system in which income distribution
has become unacceptably skewed. Ordinary people feel increasingly hard done by and insecure in the market
economy. They are disengaging. People need to be more protected against the tyranny of the market. The
market is there for the people, not the other way around. The political left feel that the crisis has been caused
by a small number of people who are largely able to escape unscathed while the common man is bearing the
brunt of the pain. Finance has got out of control and needs to be reined in. These are also valid points.
The system that has led us into crisis is unlikely to provide the answers to the significant challenges that lie
ahead in the areas of population ageing, health care, environment and climate, water, energy, food safety, etc.
What is needed going forward is a redefinition of the roles of the state and of the market and a redefinition of
the relationship between state and market. They should not be each other’s enemies, but should complement
each other. More than ever before, we need people to realise that a vibrant market economy and effective
government are partners.
In my opinion, our system needs to evolve into one of cooperative flexible government intervention in free
markets. Governments must recognise their responsibility for overall demand management and financial
stability. They must tighten financial regulation but not to the detriment of the financial sector's ability to
support a growing economy. Governments must also get smaller, not larger. They must recalibrate the
incentive structure of the welfare system and, at the same time, make sure that people do not feel
increasingly alienated. This can only happen if the private sector plays a role as well. Therefore, companies
must stop their lopsided focus on shareholder value. They must recognise their social responsibilities as well
and they must make a contribution to social inclusion. Government must be realistic about the promises they
make to individuals. This is particularly challenging and important in Europe. (Continental) Europe never
went as far as the US in adopting neo-liberalism, as it was unwilling to accept all the social dislocations that
resulted. Europe seems to have opted for a process of 'comfortable relative decline'. But that process is
unsustainable as it slowly but surely chokes dynamism and the capacity to grow. Where government cannot
keep their promises, people must learn to take more responsibility themselves, and in some areas the private
sector can perhaps play a role in delivering on the promises made by governments. Companies must
fundamentally change their attitude that they ‘know best’ and that government is a costly, good-for-nothing
bureaucracy. Companies must increasingly recognise that an active, efficient government is crucial in a
19
A phrase used by UK PM David Cameron in speeches in April 2013
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market economy. Government must accept that it needs to take responsibility to invest in new areas of
advancing technology.
Some of these developments are already underway. Mariana Mazzucato shows how the state has often
played a decisive role in the development of crucial innovations.20 It is simply not true that the market knows
best. In many cases, neither the government nor the market 'knows', but at least the government can afford to
take risks that market participants are unwilling or unable to take.
Developments in the market show that market participants can take responsibility in areas where they have
not done so before. Just look at how far we have moved from Milton Friedman's 1962 view that business
cannot bear any social responsibility other than to use its resources and engage in activities designed to
increase its profits. Today's consumers and public opinion demand that companies produce as much as
possible in a sustainable, socially responsible way. Many investors weigh social responsibility in their
investment decisions. Companies are responding. A focus solely on shareholder value is, indeed, behind us.
There is no reason to believe that this process has run its course. In fact, given the challenges ahead and the
limitations the public sector is facing, there is only one way forward: that business takes on more and more
social responsibilities.
History shows that capitalism rises to the challenges it faces. There is no realistic alternative to capitalism. It
is also hard to see democratic countries changing to an undemocratic system and following a model such as
China's. I am convinced that we will move to a new model of capitalism along the lines I have described. In
fact, I believe movement is under way. As we are still dealing with the crisis and are facing significant
challenges apart from system change, this period will be confusing and may be chaotic. This could be
dangerous.
20
Mazzucato, 2013
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