NZCPD Forum

Roger Kerr is the executive director of the New Zealand Business Roundtable, an organisation of chief executives of around 50 of New Zealand's larger business firms. Earlier he was a senior official in the Treasury and the Ministry of Foreign Affairs. He has also been a director of the Electricity Corporation and the Group Board of Colonial Limited in Melbourne, and a member of the Council of Victoria University.

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NZCPR Guest Forum
Roger Kerr
5 October 2008
The End of Capitalism? Dream On!

The idea that the US financial crisis presages the end of capitalism – the dream of Marxists down the ages – doesn’t pass the laugh test. It took no time for local members of the anti-capitalist brigade to appear from under stones. Trade unionist Matt McCarten told us in the Herald on Sunday of 28 September that “free market capitalism doesn’t work and never has”. Presumably he thinks China ’s amazing success in lifting millions out of poverty over the last 30 years stems from rigid adherence to communist economic principles!

McCarten believes that “The free marketeers’ ideology goes something like this: there should be no regulation and the market is always self-correcting.” Does he actually know anything about economics? No so-called ‘free market’ thinker has ever advocated a market without rules. He goes on to say (correctly) that those guilty of fraud in the US meltdown should be jailed. True, but in his imaginary universe there would be no fraud laws!

For someone with no economic understanding, simple logic would have come in handy. Some obvious questions can be asked.

First, why is the banking and financial system in New Zealand, Australia and many other parts of the world not suffering in the same way as in the United States and Europe? No apparent ‘crisis of capitalism’ here.

Second, why are the lightly regulated hedge funds and private equity firms in the United States much less troubled than the highly regulated banking sector?

Third, doesn’t history tell us that past financial crises typically had a large ‘made by government’ element to them, and wouldn’t one suspect the fingerprints of the ‘visible hand’ of government to be all over this crisis as well?

Scholars today widely agree that the Great Depression of the 1930s was largely caused by the Federal Reserve’s excessively tight monetary policy, ‘beggar thy neighbour’ protectionist trade policies and other errors.

It was not a ‘crisis of capitalism’ as many assumed, but this mistaken belief greatly enhanced the allure of socialism and government intervention more generally.

Similarly, many saw the East Asian crises of 1997-98 as a disastrous consequence of open capital markets, and predicted a retreat from globalisation.

Instead they were quickly recognised as largely due to governments maintaining fixed and over-valued exchange rates and controls on capital flows.

So what lies behind the present crisis, which is still unfolding and has a long way to run?

Books will be written on the subject, but plainly there is a large ‘made by government’ element to it again.

Recall that it began with the bursting of the US housing bubble and the high default rates on ‘subprime’ mortgages (risky loans to unqualified borrowers).

What caused this bubble? A prime source was easy money – the
Federal Reserve cut interest rates in response to the dotcom cash earlier this decade and kept them low despite inflation pressures and the surge in the prices of housing and other assets.

Moreover, the Fed’s 1998 rescue of Long Term Capital Management and its response to the dotcom crash led many to believe in the so-called ‘Greenspan put’ – the expectation that the Fed would reflate the economy if it struck trouble and bail out failing financial firms, especially large ones. This arguably resulted in imprudent borrowing and lending (any charges of ‘greed’ should factor this in, and be levelled at both sides of the market).

Another very important contributor was the implicit government support of Fannie Mae and Freddie Mac, the two huge corporations that back nearly half of the $12 trillion mortgages outstanding in the United States . Although privately owned, Fannie and Freddie are known as ‘government-sponsored enterprises’ and are the single biggest factor in the crisis to date. They are wards of the government, not ‘greedy private corporates’. Get it, Matt?

Their symbiotic relationship with the government was a train wreck waiting to happen. The government backing undercut private lenders and encouraged risky practices. Efforts to rectify this situation in the past (including by John McCain) were defeated by the Democrats in Congress.

As one commentator put it, “The idea that these two collapsing behemoths somehow represent a failure of the market is about as plausible as saying that the collapsing boxer falling to his knees represents a failure of the canvas.”

Another factor was political pressure on banks to lend in the name of ‘affordable housing’ (sound familiar?). As a Brookings economist put it, banks “had to show they were making a conscious effort to make loans to subprime borrowers.”

Other ill-conceived government regulation has played a part. This includes the requirements for banks in the United States (and internationally) to hold specified levels of capital. Critics have argued that they encouraged banks into off-balance sheet securitisation of mortgages and other assets which has been a prime source of the problems.

Further dubious regulations include mark-to-market accounting requirements (which helped bring down AIG) and those relating to the oligopoly status of the credit rating agencies.

Wider government interventions are also relevant. An example is land supply restrictions (so-called ‘smart growth’ policies) that helped drive up house prices in states like California . The fall-out has been milder in less-regulated jurisdictions like Texas .

Another is the plethora of regulations restricting mergers and takeovers of under-performing firms in the United States .

All these prior follies made the current bailouts virtually inevitable.

None of this is to argue that there were not serious failures by boards and managements of banks and other institutions. Many of them have been rightly punished through shareholder losses and management firings.

Questions will rightly be asked about corporate governance and executive pay. But knee-jerk reactions here make no sense – the United States has learned to its cost the folly of over-regulation in the form of the Sarbanes-Oxley Act in reaction to the Enron collapse. New York ’s diminished status as a financial centre relative to London and Hong Kong has been the result.

In relation to proposals to limit executive pay, which Matt McCarten would no doubt support, University of Chicago legal scholar Richard Epstein has written:

“Not smart. Envy is a bad emotion. Of course, everyone should be astounded that the pay of CEOs can go through the roof, even though at Fannie and Freddie it should have gone through the floor. Still it would not be a bright idea for the bailout plan to [regulate executive pay] … After all, private equity companies always pay their key inside officials more than public corporations do theirs. If we want people to put their reputations under the guillotine, then we have to compensate them before their broken careers are carted off in tumbrels to some management graveyard. We need able people, not low salaries.”

You would think that the spectacular record of government failure in respect of financial institutions in the United States would have alerted Matt McCarten to conclusions to be drawn for New Zealand .

But no. He recalls the failure of the Bank of New Zealand and the taxpayer bailout in the early 1990s as another sobering lesson in “free market capitalism”. Hello Matt! – it was yet another case of government failure. The BNZ had majority government ownership and an implicit government guarantee.

It is too early to understand all the factors behind the present crisis and the lessons to take from it.

There will rightly be debates about regulation, and there is plainly scope for better regulation, but it is clear that we have learned yet again that much regulation does more harm than good. Also, as the Wall Street Journal noted, “Adam Smith, that great market disciplinarian, is punishing excess and remaking American finance long before Congress can get into the act”. New Zealand ’s relative immunity from the turmoil suggests our less intrusive regulatory framework is in better shape.

When the dust has settled, however, one thing is certain: Matt McCarten is going to be disappointed. Market-based economic systems – what he likes to call capitalism – will not be abandoned.

It is true that they can have harsh effects: capitalism is a system of profits and losses, and both are important in guiding society’s resources to their most valuable uses. Markets need regulations and ethical standards to operate efficiently. They do not need government interference which adds to normal fluctuations in markets and makes them unstable.

There are still a few countries in the world like North Korea , Cuba and Myanmar with the kind of economic systems Matt McCarten appears to prefer. (I recall another trade unionist, Bill Andersen, saying on radio that East Germany was his favourite economic model, only months before the Berlin Wall came down.) But over the last 25 years, most countries around the world have moved in the direction of freer market economies because their wealth-generating capabilities relative to alternatives are unsurpassed. Sorry, Matt: don’t hold your breath for any turning back.