THE END OF CAPITALISM? MARK TWAIN, LAKE WOBEGON, CURRENT CRISIS

By Mark Blyth

While the type of financial crisis we face today is unprecedented, crises of capitalism are not. They are commonplace.
Mark Blyth is a professor of international political economy at Brown University. He is the author of Great Transformations: Economic Ideas and Political Change in the Twentieth Century.

If you draw what statisticians call a time series of the returns to the U.S. banking sector from 1947 to 2008, it is possible to talk with some confidence about the average rate of profitability of the sector over time, the peaks (1990s to mid-2000s), the troughs (1947 to 1967), and the sharp growth of the sector’s profitability over the past 10 years. If you then add in the data for the period between August 2008 and April 2009, the entire series, like the banking system it describes, simply blows up. Averages, means, variances, and the like dissolve, so extreme have been recent events. Indeed, when the former chairman of the U.S. Federal Reserve Bank, Alan Greenspan, admits that his understanding of market processes was deeply flawed, and when the current chairman, Ben Bernanke, says that we face the greatest crisis since the Great Depression, we should probably take it seriously.

And serious it is. With a grossly diminished $1.3 trillion in assets and as much as $3.6 trillion in liabilities, coupled with a halving of the stock market, the U.S. financial system is either severely stressed, insolvent, or, worse still according to some, at the end of its tether. The end of capitalism has been declared many times before. And yet, to paraphrase American writer and humorist Mark Twain, reports of its death have been greatly exaggerated.

The U.S. capitalism that will emerge from this crisis will be different from the highly financialized consumption-driven and trade-imbalanced version that we developed over the past two decades. It already has changed insofar as Wall Street proper no longer exists. But what people tend to forget is that we have been here before. While the type of crisis we face today is unprecedented, crises of capitalism are not: They are commonplace. It’s just that this one has hit the United States rather than another region of the world. But we have been here before and have survived, mainly because the present is not a copy of the past. Remembering this tempers the expectation that U.S. capitalism has run its course.

The Lake Wobegon Problem (where everyone is above average)

While there are surely many plausible candidates — ranging from the bonus culture of banks to Chinese savings and German parsimony — to blame for the crisis, focusing on the immediate present may mask a deeper set of causes. Putting this crisis in proper perspective requires that we begin almost 30 years ago with the unexpected marriage of unlimited liquidity and limited asset classes. Six processes came together to get us where we are today.

First, beginning in the 1980s, the world’s major financial centers deregulated their domestic credit markets and opened up their financial accounts. This “globalization of finance” resulted in a spectacular growth in available liquidity as previously isolated markets became intertwined. Second, this liquidity was given a huge boost with the growth of new financial instruments, particularly techniques of securitization and the increasing use of credit derivatives. Third, given this growth of global liquidity, long- and short-term interest rates began to fall precipitously. In 1991 the U.S. prime and federal funds rates (and thus global interest rates) began their long decline out of double figures to historic lows.

Fourth, given these changes, the commercial banking sectors of these now finance-driven economies became increasingly concentrated. Available bank credit skyrocketed at the same time as the privatization of former state responsibilities, especially in pensions, encouraged the growth of large non-bank institutional investors, all seeking “above-average” returns since their jobs depended upon beating some benchmark average, usually the annual return of the Standard & Poor’s 500 stock index or an index of their sector’s performance.

Fifth, the U.S. current account deficit climbed to historically unprecedented proportions of the gross domestic product. The United States was effectively borrowing between 3 and 6 percent of GDP each year for more than 20 years, and borrowing at such low interest rates seemed to make money free given the growth rates that we grew accustomed to.

Sixth, and perhaps what facilitated all of the above, was a deep seated ideological change that took place in the United States between 1970 and 2000. Namely, markets came to be seen by politicians, pundits, and the public as self-regulating wonders that could produce ever higher risk-free returns if only the state’s blundering and inefficient regulations could be swept away, which they were by obliging politicians of both parties. Add all this together and you have a financial sector that is both dependent on continually finding above-average returns at the same time as it becomes an increasingly large and important part of U.S. gross domestic product.

The Limits of Lake Wobegon
The problem with chasing a moving average is that it continually gets bid upwards. Here we run into a problem of asset classes: the limited number of categories of assets from which investors can seek above-average returns. There are only a few such classes around: equities (stock), cash (money market), and fixed income (bonds), to which one can add real estate and commodities. If equities, bonds, and money market instruments are regarded as reciprocal investments within a class, then stock markets, relatively underpriced in the early 1990s, became the obvious place to go for such returns. The massive volume of liquidity in its search for above-average returns first flooded U.S. equity markets and quickly thereafter hit global stock markets during the middle to late 1990s.

Once that particular bubble burst, most spectacularly in East Asia, neither bonds nor fixed income alone would provide the above-average returns that the markets — and all of us who depended on them — now expected. The next stop for investors was therefore the ill-fated dot-com bubble, and thereafter the next most obvious asset class, real estate — hence, the global housing boom, which began just as the dot-com bubble popped in the late 1990s. By 2008 this housing bubble had run out of (good) borrowers, in part owing to Federal Reserve Chairman Greenspan’s raising of interest rates in the mid-2000s. The result of looking for a new return was that the remaining class of assets, commodities, became the next bubble, with oil quadrupling in price and basic foodstuffs rising between 40 and 70 percent in a little over a year. However, with the exception of oil, these were small markets, too small to sustain such volumes of liquidity, and these bubbles burst quickly. The commodity market collapse combined with losses in the subprime sector of the mortgage derivatives market triggered the current crisis.

Although it is referred to as the “subprime crisis,” it is perhaps better described as a subprime trigger for a systemic crisis caused when all these factors came together through financial actors’ risk management practices. While banks and other financial firms have sophisticated models for managing their various risks (credit, liquidity, and the like), those same technologies can create instabilities in markets by either blinding their users to tail risks, which causes a channeling of risk into common portfolios across asset classes as everyone hedges the same way, or by linking assets together in a search for liquidity as positions are unwound as banks de-leverage. So what is rational for one bank can create systemic risk for all banks as asset positions become serially correlated on the upside and the downside of the bubble.

Once the entire banking system had loaded up on mortgage derivatives and credit default swaps, the crisis was just waiting to happen. It came when losses at several major U.S. banks triggered the fall of Lehman Brothers, which in turn caused massive losses in systemically linked markets, particularly the massive credit default swaps market. Liquidity dried up, and the crisis had begun. How it unfolds from here is really anyone’s guess, but does this mark the end of American capitalism? There are several reasons to think that this is not the case, and that Mark Twain’s injunction still stands.

Mark Twain and Three Reasons to Be Hopeful
It is worth noting that while Federal Reserve Chairman Bernanke said that we faced the greatest crisis since the Great Depression, he did not say that we face a crisis as big as the Great Depression. Twenty to 40 percent unemployment, a collapse of world trade, ruinous competitive currency devaluations, absurd tariff levels, and the collapse of democracy were the reality of the Great Depression across the world. We face challenging times in the current crisis, and there is always the possibility that things could get much worse, but things are nowhere near this severe. This gives me reason for optimism regarding Twain’s observation, mainly because there is a huge difference between the world of the 1930s and the world that we live in today. Time’s arrow means that we always “live it forward,” such that the conditions of the present are never the same as the conditions of the past. Three of those conditions that pertain today and that are different from those of the 1930s give us the opportunity to avoid the mistakes of the past.

The first lesson learned is that lessons can be learned. We are not doomed to repeat the 1930s precisely because we can reflect upon how bad the 1930s were and how actions taken to protect ourselves individually in this period made us all worse off collectively. Those lessons learned made states across the world build automatic stabilizers into their economies in order to stave off collapses in consumption that would lead to protectionist and nationalist demands in the event of an external crisis, and to rely on multilateral cooperation to forestall obvious policy errors. One can legitimately argue that different countries learn different lessons. Hence, the Germans are worried about the inflationary consequences of the spending the Americans want the Europeans to undertake to avoid the unemployment that the Americans fear. But the point of meetings such as the G20 is to air those differences and find room for policy agreements. The question is one of balance between stimulus and regulation, and both sides of the Atlantic know that they need to find common ground to move forward.

My second reason for optimism derives from the new MAD. During the Cold War, we spoke of “mutually assured destruction,” in which the United States and the Soviet Union had so many nuclear weapons that one side could not destroy the other without destroying itself. Swap “mutually” for “monetarily” and you get the new MAD — “monetarily assured destruction” — which exists between China and the United States. One consequence of the financialization of the U.S. economy was that we managed to get China to swap real goods for paper, and a terrible rate of return on holding the paper, for more than 20 years, in the course of which the Chinese (and other East Asian economies) built up astonishingly large trade and current account surpluses. Essentially, without anyone ever making such a wager formally, the United States made a one-way bet that we could run our economy on finance in a global division of labor in which China made the goods in return for dollars that would be lent back to us so we could consume their products. That system has also come to an end. China needs to consume more and the United States needs to produce something besides mortgage derivatives, and both sides know this. Getting there will be painful, but the alternative, monetarily assured destruction, where the dollar is dumped and the exchanges collapse, is another individually rational and collectively disastrous policy that all parties know, this time around, to avoid.

Third, another ideology has failed. The belief that markets are uniquely good and self-regulating entities, while states are always and everywhere bad and overregulating monstrosities, is a recurring nightmare in the history of capitalism. The 1930s taught us that this belief in markets and self-regulation was fallacious and gave us the Keynesian era of regulated finance and welfare states. The 1970s, the other crisis period of the 20th century, taught us that Keynes was wrong and that open markets and unregulated finance were the way to go. That system, what might be called neoliberal globalization, was the system that just blew up. So what will be the lesson learned this time?

The lesson still to be fully learned from this crisis is that markets and states are always and everywhere mutually overlapping, constitutive, antagonistic, and generative. Capitalism as a system thrives best in an environment of prudential regulation provided by states, and U.S. capitalism is no different. The precise balance between state and market is a political question to be decided by different states. But that there needs to be a balance is something that most states, even the United States, now accept.

So Mark Twain’s injunction stands. Reports of the death of U.S. capitalism are exaggerated and will likely remain so as long as we are willing to learn that lessons from the past can indeed be learned.

The opinions expressed in this article do not necessarily reflect the views or policies of the U.S. government.

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