Soul-Searching on Capitalism

November 27, 2012

Global economic woes prompt soul-searching on capitalism

by Larry Elliott, economics editor,Sunday 25 November 2012 13.57 GMT The Guardian

Hope springs eternal: China’s manufacturing sector has perked up a bit; there are encouraging noises coming out of Washington about avoiding the fiscal cliff; the euro is still in one piece – could it be that recovery is coming at last?

After all the false dawns, this could be the point at which capitalism shows its resilience and regenerative powers. Since the birth of the modern industrial age more than 250 years ago, there have been only brief deviations in the upward trend of production. The Great Depression looks like a mere blip on the upward sloping graph of UK or US GDP.

Even so, the depth and length of the crisis has led to a degree of soul searching. While policymakers insist publicly that vigorous recovery will eventually arrive, there is private concern that deep structural problems are blunting the effectiveness of a stimulus unprecedented in its scale, scope and duration. These concerns are well founded.

To understand why, it is necessary to look at the basic ingredients that historically have made capitalism tick in all its many guises, be it America’s free-market approach, Sweden’s welfarist model, or China’s state-run variant.

The first requirement is stability, without which entrepreneurs will not take risks. In the early stages of development, this means adherence to the rule of law and a system of property rights that guard against expropriation. As economies grow more sophisticated, it comes to mean additionally a degree of economic and financial stability. Those taking long-term investment decisions need to feel confident that there will be a steady stream of returns and that the banking system is robust and well-managed.

The second prerequisite is legitimacy, which is not the same as fairness or equality. Capitalism is neither fair nor equal, and never will be, but large quantities of fairness have been injected to ensure it has retained political legitimacy.

Quite early on, in the first half of the 19th century, it became clear to the more far-sighted capitalists that a method had to be found of ensuring that a rising tide lifted all boats. The observations of Karl Marx and Friedrich Engels on the immiseration of working people in Britain’s industrial revolution were accurate but, even then, steps were being taken to improve living standards.

Some of these were self-help measures by workers (trade unions, friendly societies); others were the result of pressure from social reformers and politicians (better sanitation, expansion of education).

Later, starting with Bismarck in Germany, there was the development of a system of old-age pensions, stage one in the creation of welfare states. By the middle of the 20th century, an array of checks and balances were in place to ensure the fruits of growth were shared – from progressive taxation to the US’s 1944 GI bill, paying extra benefits to more than 2 million returning soldiers.

Sustainability is the third ingredient needed for capitalism to work. Companies that deplete their capital, either physical or human, can thrive for a while but eventually run into problems. Consumers who finance their spending by borrowing against rising property values eventually find the debt burden too much to sustain. It is not sustainable, either, for one group of countries to run permanent balance of payments deficits while another group racks up big surpluses year after year.

In recent years, fears over climate change has added another dimension to the problem of sustainability: the dangers of using up capital quicker than it is being replenished apply not just to companies but to the planet.

Fourthly, there’s creativity. The west won the Cold War because industrial capitalism was quicker on its feet than the Soviet brand of Marxist-Leninism. Capitalism was good at giving consumers what they wanted, even though some might argue that some of those wants were generated by clever marketing and aggressive advertising.

Old industries declined and new industries took their place. Companies that failed to make profits went out of business, with resources – eventually, and often after a tough period of re-adjustment – reallocated to growth sectors of the economy.

Finally, there’s profitability. Before new and more efficient production methods for agriculture and industry were developed in the 18th century, per capita incomes in the west had risen at a glacial pace for more than 1,000 years. Modern industrial capitalism generated surpluses and it was this that differentiated it from the subsistence model.

The story of capitalism in the postwar world, before the current crisis, falls into two phases. In the first, there was a great deal of macroeconomic and financial stability. Recessions were rare, banking failures virtually unknown. The system was legitimate because living standards were rising across the piece, and the gap between rich and poor narrowed. Consumers funded their spending out of rising incomes rather than through debt, while the Bretton Woods system ironed out balance-of-payments problems. With climate change not yet on the agenda, the system looked sustainable.

Whether the Golden Age met the other two criteria – creativity and profitability – is a controversial question. Economists such as Friedrich Hayek and Milton Friedman argued that attempts to make western economies more stable and more equitable had, in reality, sapped their strength. Companies were feather-bedded, workers paid more than they were worth, creativity was stifled.

As a result, the second postwar phase saw a greater emphasis on creativity and profitability. Life was made tougher for workers, easier for entrepreneurs. Trickle-down economics, it was argued, would lead to everybody being better off; the magic of the market would guarantee that economies were sustainable; control of inflation and self-regulation would ensure stability.

The crisis exposed the weaknesses of this approach. In 2008-09, capitalism was in serious trouble because the system was unstable, illegitimate, unsustainable and unprofitable. Banks were on the brink of going bust, there was public disgust at the antics of the financiers, many years of weak income growth had left consumers hooked on debt, and global industrial production and trade were collapsing.

What has happened since? There has been an improvement in corporate profitability, especially in the US, as jobs have been shed and wages held down. Austerity for the many and booty for the few is not doing much on the legitimacy front. Measures to make capitalism more sustainable – a bigger share of the cake for labour, the running down of surpluses by Germany and China – would help give it greater legitimacy. Little progress has, however, been made when it comes to redistribution of the spoils or global rebalancing: none at all when it comes to ensuring the sustainability of the planet.

Thanks to the efforts of central banks and finance ministries, a degree of stability has been restored. There is no longer the risk, as there was in October 2008, that cash machines will run out of money. On the other hand, emergency measures to rescue capitalism have become permanent fixtures, with the result that rock-bottom interest rates and quantitative easing are hampering rebalancing and readjustment.