Economic Crisis and Capitalism

Economic Crisis The recession of 2008-2009 and the subsequent government responses provides a good test for economic theories. There are no controlled experiments in economics, so we can only work with case studies in order to understand how economies work. A good starting point is to consider the issue through multiple different lenses, so that we can understand how the crisis occurred and what prescriptions might be best suited for response either to address the root problems or to engage in prevention.

This paper will consider the works of Marx, Schumpeter and Keynes in analyzing the financial crisis. All three of these men would have been able to understand its causes, but likely would have taken very different approaches to solving the problem. The second issue at hand is the question of the future of capitalism.

We have a pretty good sense at this point of what the response of government is to the threat of such crises going forward, but each crises also presents us with new information that we can use to best understand how are governments can and should set up the economic system of the future. There will be some discussion about the future of capitalism then, synthesizing what we already know and what will likely take place in the future.

Karl Marx was one of the most important economists and he fairly accurately understood the nature of capitalism. He might be better known for the failures of his strongly socialistic response to capitalism, that doctrine having been roundly refuted in practice. However, his understanding of capitalism can inform us of the past recession and what the responses should have been, and perhaps should be in the future.

Marx noted that capitalism was a distinct form of economic organization in that it requires and supports the advancement of capital in the form of profit. This profit, he argued, can exist on the individual level but for an entire economy is only possible for economy-wide profit to occur through exploitation. He argued that it was exploitation of the worker, though this particular line of thought is probably related more to his political views than an accurate assessment of economics.

Arguably, it is the negative externalities such as the exploitation of common resources or the adding of pollutants to the atmosphere that represent the means by which an economy as a whole can profit (Wolff, 2010). In Das Kapital, Marx wrote that capitalism also promoted a cycle of "stagnation, prosperity, over-production and crisis, ever recurrent." Ever the optimist, he noted that the cycle was most typically broken by depression.

He noted that the pursuit of profit would typically lead to excesses, and these excesses will inevitably be checked by economic bust, for example when production dramatically exceeds demand, leading to a situation where too much capital is tied up in goods that are illiquid. Marx's understanding of the economic crisis in 2008-2009 would certainly have been one of resigned expectation. He would have known that there are boom and bust cycles.

The moves away from government control of certain sectors, banking especially, were likely to lead to increased volatility in those markets. The problem of course is that the banking system underpins all economic activity. Boom and bust cycles in the banking system are inherently much more destructive that boom and bust cycles in the chicken & waffles industry. Marx would also have noted that when the crisis hit, the workers suffered.

They were the ones who began to lose their jobs as the result of the credit crunch, for example, and it was individuals who were frequently saddled with the illiquid assets in the form of houses. Marx would therefore have been especially dismayed at the policy response from the U.S. government. Where funds were made available, they were typically made available to the financial sector.

While individuals were left with illiquid assets, the concern was mainly for the well-being of the banks and the equally illiquid mortgage-backed securities that they held. Marx would have instead advocated payments to the workers, as he would have seen banking industry profits as coming from the exploitation of the workers.

Indeed, the subsequent rapid return to profits at the banks, with the large bonuses and the rapidly-rising stock market, stand as some of the strongest support for his theory about profits deriving from worker exploitation that exists in economic history. Marx would surely have also advocated much stronger regulations on the banking system, knowing that it is the workers who suffer from banking industry excesses. While he might not have used the phrase moral hazard, he surely would have understood the concept and readily adapted it to the financial crisis.

Schumpeter Schumpeter was an advocate of the idea of creative destruction, which has some interesting implications for how he would have viewed the crisis. Schumpeter would have naturally expected that with few restrictions on banking activity some sort of destruction would naturally have taken place. He would have understood that easy credit was going to be a problem, but more important he would have recognized the hazard played by evolving innovation. The financial instruments at the heart of the crisis -- the mortgage-backed securities -- were inherently riskier than advertised.

Schumpeter was keen on the idea that innovation brings about both boom and bust, and that sometimes a new innovation can prove destructive. In the long run, such destructive innovations will be removed from the economic system but in the short run they can wreak havoc (Eichengreen, 2010). Innovations are positive in general, but certain individual innovations are negative in their nature and that this is a threat. It is doubtful that Schumpeter would have approved of the policy response to the crisis.

He was into behavioral economics (Eichengreen, 2010) and would have surely noted the moral hazard of the too big to fail doctrine. While not a proponent of market intervention in terms of regulating or banning these products, he would naturally have also avoided bailing out the banks. To do so would interfere with the forces of the market. Not only would this create a moral hazard but it would fail to instill the lessons on the financial industry about the dangers of its innovations.

We saw not too long after during the Dodd-Frank debate that the financial industry was up in arms about regulation of dangerous products, precisely because it did not have to pay the cost associated with these destructive instruments. Schumpeter would have preferred that the financial industry suffered for a long time in order to learn the valuable lessons.

Yes, this would have meant much worse total economic outcomes but ultimately the economic will be better for it, because a new form of innovation or even a new economic system would emerge. Schumpeter would have viewed the policy responses of the Congress and the Federal Reserve as putting a Band-Aid over a broken economic system instead of letting that system die a natural death to be replaced with an improved system.

Keynes John Maynard Keynes was probably the least of the three at predicting the crisis, because he was in favor of the idea that deficient demand was a major problem (The Economist, 2013). The lack of demand, however, only came after the supply of money was constricted. So in a sense, Keynes was probably the least-equipped of the economists studied here to understand the nature of this particular crisis. His understanding was colored by his social setting -- something that Schumpeter in particular was cognizant of.

Keynes was doing his economic thinking in a world where there was very little in the way of arcane financial instruments. The importance to the economy of something like derivatives was minor compared with now, where e a lot of value is created simply through speculation. At the heart of the crisis was that a bubble was being created where the value of the derivative asset was far greater than the value of the underlying asset -- not something that was particularly relevant in Keynes' model.

However, Keynes would have had a different policy prescription in terms of how to address the crisis. Where the bulk of the policy response centered around supply side economics, Keynes was a believer in demand. The government took measures to pump money into the banking system and enact free monetary policy. While these have certainly allowed for an inflation in the value of the stock market, there remains generally modest economic growth and unemployment is still quite a bit higher than the pre-recession level.

Keynes could have advocated more direct stimulus into the economy, where government spending is used to substitute for the suppressed demand from business and consumers. Once the condition of insufficient demand was identified, Keynes would have advocated such a policy as a means of getting the economy back on track. The actual policy was less effective, quite frankly, because a lot of the money that the government pumped into the banking system ended up sitting on the sidelines. Businesses were not interested in expanding, because there was insufficient demand.

Demand was not the root cause of the crisis, but it was the area where the policy response should have been focused in order to pull the economy out of the crisis. Synthesis What all three economists understood was that the supply side response was not going to address the problems in the economy. They understood this in different ways. Keynes would have wanted an increase in government spending directly into the economy as a means of increasing aggregate demand.

Marx would have advocated similar -- restoring wealth to the workers in order to restore balance to the economy, though he might have taken this farther than Keynes. Schumpeter would have probably taken a hands-off approach and let the banks and the economy suffer in order to develop a stronger version of capitalism in the future. Schumpeter's view was not particularly practical politically, and it is worth knowing that the government was not acting out of strictly economic doctrine.

While Marx and Schumpeter in particular fully understood and accept that capitalism will have strong cycles -- ok Marx probably did not accept this but he understood it -- the voting public cannot accept this because they are the ones that suffer the most from the economic collapse. Thus, politicians cannot simply seek the perfect economic solution because they are charged with creating conditions of stability, taking the volatility out of the natural market conditions.

This is done through intervention and regulation, which we know will reduce the economic efficiency of the market. So while all three of these economists would have questioned the policy decisions of the Bush and Obama regimes, they would also not have been able to implement their own ideas either. There is no tolerance for the sort of prolonger depression that Schumpeter would have advocated and it is highly doubtful that America is ready for a sharp turn to a Marxist economic society.

Keynes, on the other hand, would have offered what should have been a politically palatable solution. That it was harder to execute that one might expect is a story for another essay, but clearly his response had the best balance of economic and political logic. Future of Capitalism The first thing that we have to realize with the future of capitalism is that we are not going to have the creative destruction that Schumpeter would advocate.

As noted, this is simply not politically viable, so it will not come to pass. The response was essentially putting a Band-Aid over the wound, and hoping that the next wound will not be bigger. It might be, if present policy is anything. The Dodd-Frank financial reform package was narrow and largely toothless. Where a smarter policy might have been to turn to a system of financial industry regulation that emulates success stories like Australia or Canada (Isfeld, 2012), that has not occurred.

The strong regulations of those countries essentially serves to smooth out the volatility of free capitalism. The lack of such meaningful bank reform in the U.S. makes it almost inevitable that the economy will suffer future bubbles and shocks. Marx and Schumpeter both predicted this, and offered policy prescriptions to address this, but these prescriptions are ultimately too radical for the modern American audience -- or any Western audience really.

So capitalism is most likely going to lurch along in its current form until a crisis arrives that is so strong that the system will need to be revisited. There are strong vested interests in the current system, including most of the people who live under capitalist economies, since they tend to have the highest standards of living. In the grand scheme of things, efficient capitalist economies are still the best generators of wealth.

It is simply the choice of government to determine how much innovation in society it will allow, in essence how much volatility it can handle. In the United States, there is considerable risk with current policy. In particular, the majority of Americans seem to suffer from such crises, but those who create the crisis tend not to be the ones suffering.

As a result, there is no incentive to adopt smarter economic policy, as would happen if the suffering was directed at those who create the problems, as Schumpeter would prefer. By socializing the losses, considerable moral hazard is created (Liu, 2008). The current policy in the U.S. is going to inevitably lead to further boom and bust cycles. The assets will be different, and the strongest cycles will be the ones that, like in 2008-2009, are in relatively illiquid assets.

There will be stock market busts as well, but with a more liquid asset they will not be as intense as ones in housing or natural resources or other illiquid assets. But the crises will come, and that is something widely predicted by history's top economists. In the long run, if the market was allowed to learn its lessons, it would as Schumpeter argues not be forced to repeat its mistakes.

This is where people start wondering about the future of capitalism, because there is little in the way of learning opportunities. As Dodd-Frank shows, the vested interests are able to retain their gains while socializing the losses so they have no incentive to change. The lack of political will be change that element of the system means that the 2008-09 crisis will inevitably be repeated. The tipping point for capitalism is not likely to come, however.

Overall, even if economic growth stagnates, Americans and people in other Western countries live well. They are not in a position to suddenly become risk-takers and adopt a more radical ideology. There will be Band-Aids thrown on bigger and deeper wounds well past the point where the system should have been overhauled. These Band-Aids will seek to alter the balance between growth and innovation and the need to smooth out the economic cycles. The U.S. may one day resemble more of a Canadian economy but it may not.

Ultimately, however, capitalism's cycles can be managed and that alone would make any risk -- averse individual reticent to evaluate other systems. Marx would see this as a problem because of worker exploitation, and Schumpeter.