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Capitalism and the credit crunch Longer version of an article by Samuel Brittan that appeared in the Financial Times 11/09/08 What does the great credit crunch do to the case for competitive capitalism? It is surprising that this question is not more often asked. While a few irredentist left socialists are now muttering "I told you so", the think tank free market enthusiasts seem content to discuss micro issues such as the case for denationalising postal services or, at most, reflect on man's propensity to truck and barter. The pragmatists in the middle are far too busy dealing with day to day shocks to bother about systemic analysis. Yet the broader question does matter. Politicians in both the Blair and the Brown wings of the Labour Party as well Social Democrat members of the German coalition government and many others have not only risked their careers to make the case for market forces, but have had to jettison their deepest lifetime convictions. This is not to speak of non-partisan working economists who have spent years explaining competition and the market mechanism to their not always sympathetic employers. Are they now to stand on their heads and say that they have been wrong all along? And even if they did where would they turn? The fully collectivist Soviet Gosplan model has been tested to destruction. The more limited interventionism of the 1950's and 1960's, about which some commentators are so nostalgic, mainly represented lingering World War Two controls. Plus populist subsidies to massage downwards cost-of-living indices which contained fewer items than today's consumer price indices. Even if the alarmists are wrong and in the end we suffer no more than average post-World World War Two recession they will still be able to say that we had a narrow escape due to the readiness of leaders like Hank Poulson, the US Treasury Secretary, not merely to jettison free market principles buy to take risks with common prudence to bail out US corporate bodies. In any case the widespread fear provoked by recent financial events will ensure that there is no "glad confident morning" for free market principles for a long time to come. It is for such reasons that I welcome a short and well written book The Origin of Financial Crises (Harriman House �16.99) by George Cooper which attempts to relate apparently esoteric financial issues to elementary economic theory. Cooper has worked for several financial institutions and ended up as London head of interest research at JP Morgan. The most important thing he has to say comes right at the beginning and does not depend on the more controversial financial proposals he subsequently develops. He starts with a quotation from Paul Samuelson, Nobel Prize winner and author of what was probably he best selling economics textbook of the 20th Century. Samuelson provides a simple introductory outline of a competitive market system. If there is a flood of new orders for, say, shoes, their price will rise and more pairs will be produced. If there is a glut of tea, its price will be marked down, people will drink more tea and producers will supply less. "Thus equilibrium of supply and demand will be restored." Samuelson, who is as far as it is possible to be from a market fundamentalist, knows that this is not the end of the story. There can be market failure due to environmental overspill, monopoly power, lack of incentive to provide public goods and numerous other factors. But if we look to officials for remedial action they too are subject to "government failure", a simple example being the capture of regulatory authorities by those whom they are supposed to regulate. Moreover the conditions that favour innovation and entrepreneurship are not always the same as those which provide for the best outcome at any given moment. Where one ends up in this debate probably depends more on temperament than econometrics, but at least the ground rules are clear. Cooper's criticism is reserved for what looks like a throwaway sentence at the end of Samuelson's account. "What is true of the market for consumers' goods is also true of markets for factors of production such as labor, land and capital inputs." Cooper concentrates on capital, the market for which he believes is entirely different from that for consumer goods. The key distinction is between products which are valued for their sake - "use value" in Marxist jargon - and those which are valued wholly or partly for their future resale value and are therefore prone to bubbles. Care is needed here; for bubbles can take place in products which few accountants or economists would regard as capital, an example being the Dutch Tulip Mania of the early 18th century. On the other hand the purchase of a cotton mill is nowadays rarely undertaken for a speculative capital gain. These considerations lead up to Cooper's main contention that asset markets are peculiarly vulnerable to boom and bust, and are therefore the real destabilising force in the financial system, while central banks concentrate on consumer prices which he believes will largely take care of themselves if asset prices behave. At this point something called the Efficient Markets hypothesis appears and reappears like King Charles's head throughout Cooper's book. This started with innocent and necessary observations such as the irrelevance of a share's past performance to its future behaviour or the way the effects of a public policy move depend on the policy regime believe to be in operation. Unfortunately it blossomed out into the belief that assets are always and everywhere correctly priced. Indeed there were analysts who believed that the Nasdaq Composite Index was correctly priced at 1,140 in March 1996, again correctly priced at 5,048 in March 2000 and still correctly priced in October 2002 when it fell back to 1,140. No doubt if you buttonhole someone at random in a Wall St or Throgmorton St bar he will probably never have heard of the Efficient Markets hypothesis, but I will take Mr Cooper's word that it lies at the basis of the models prepared by those famous rocket scientists in the backrooms. And in diluted form it may lie behind the reluctance of modern central banks to act on asset bubbles. This contrasts with the dictum of the old school Fed chairman McChesney Martin that the Fed's job was "to take away the punchbowl just when the party gets going". His words are doubtless too metaphorical for today's tastes; but he could be right. Cooper's most novel doctrine is that investors do not have to be irrational to generate bubbles. They simply do not have the knowledge required by the Efficient Markets hypothesis. One only has to think of the diversity of views about the correct multiple of wage earnings to apply to find the equilibrium value of the UK housing stock. But is not this ignorance a barrier to the official action on asset prices, which some would like to see supplement and others to replace altogether the consumer price targets which prevail today? Yet however difficult it is, I feel confident that the rethink which is bound to follow the present credit crunch is bound to make more room for asset prices in central bank objectives than exists today even at the cost of some intellectual untidiness. Readers will not be surprised that Cooper traces present difficulties to the rapid growth of credit encouraged by the Fed's ultra cheap money policy of a few years ago. Interestingly enough an IMF working paper by Noureddine Krichene (WP/08/130) employing state of the art techniques shows convincingly that during the years 2003 - 2007 there was no one shock confined to oil or any other commodity but a parallel increase in nearly all commodity prices. During this period consumer prices remained subdued, thus giving a false sense of security. Indeed there was much muddled talk about deflation in the early part of this period. Now the chickens have come home to roost in that combination of inflation and recession that constitutes such a nightmare for central banks. The IMF author has no doubt that we are seeing" the delayed effect of an overly expansionary monetary policy which led to a vast expansion of all types of credits, irrespective of credit worthiness." I still worry about what the effects of a tighter policy would have been in the face of large Chinese and OPEC saving surpluses. But it may be that the US could have continued to be a consumer of last resort even without a Fed stimulus. To return to the broader question about competitive capitalism with which I started. Nothing that has happened suggests that governments are any good at picking winners, that freeing international trade is a bad thing or that consumer choice should be overridden. But we need to be reminded of the dictum of Keynes, uttered in the 1920's when he was still an orthodox economist, that "money will not manage itself" which should now be amended to "money and credit will not manage themselves".
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