Wednesday, April 15, 2009

a huge social insurance system, with resulting high taxes, low take-home pay and low wealth, may not hurt capitalism

TO BE NOTED: From the FT:

Uncertainty bedevils the best system

By Edmund Phelps

Published: April 14 2009 19:50 | Last updated: April 14 2009 23:50

Ingram Pinn illustration

In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards. Ignorance of what it can contribute has in the past led some countries to throw out the system or clip its wings. Ignor­ance of the hazards has made imprudence in markets and policy neglect all the more likely. Regaining a well-functioning capitalism will require re-education and deep reform.

Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud. These systems may lack the requisite political support and cause social stresses without subsidies to stimulate inclusion of the less advantaged in society’s formal business economy. Last, a huge social insurance system, with resulting high taxes, low take-home pay and low wealth, may not hurt capitalism.

In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge – with much uncertainty in the process, owing to the incompleteness of knowledge. Growth in knowledge leads to income growth and job satisfaction; uncertainty makes the economy prone to sudden swings – all phenomena noted by Marx in 1848. Understanding was slow to come, though.

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? Joseph Schumpeter’s early theory proposed that a capitalist economy is quicker to seize sudden opportunities and thus has higher productivity, thanks to capitalist culture: the zeal of capable entrepreneurs and diligence of expert bankers. But the idea of all-knowing bankers and unerring entrepreneurs is laughable. Scholars now find that most growth in knowledge is not science-driven. Schumpeterian ­economics – Adam Smith plus sociology – captures very little.

Friedrich Hayek offered another view in the 1930s. Any modern economy, capitalist or state-run, is a great soup of private “know-how” dispersed among the specialised participants. No one, he said, not even a state agency, could amass all the knowledge that each participant “on the spot” inevitably acquires. The state would have no idea where to invest. Only capitalism solves this “knowledge problem”.

Later, Hayek fleshed out a theory of how capitalism makes “discoveries” on its own. He had no problem with the concept of an innovative idea, for he understood that, even among experts, knowledge is incomplete about most things not yet tried. So he felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” (as Hayek’s hero, David Hume, would have put it) a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism. The latter are too bureaucratic to learn about ideas from below and unlikely to obtain approval from all the social partners of the ideas that do get through.

Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place. The freedoms borne by England’s Glorious Revolution of 1688 and the “commercial society” of the Scots were not enough. There had to be financial institutions where there would be disinterested financiers, each trying to make the best investment, and – importantly – a plurality of views among them, so financiers funded a diversity of projects. There also had to be limited liability for companies and a market enabling their takeover. Such institutions had to wait for demand by wide numbers of business people wanting to build a new product or new market or new business model. Rudimentary institutions began to emerge early in the 19th century, from company law and stock ex­changes to joint-stock banks and “merchant” banks lending to industry.

Unprecedented rewards soon followed in Europe and America: new cities rising, unbroken productivity growth, steadily climbing wages and generally high employment. Lifetime prospects improved for all or nearly all participants. Less measurable but ultimately fundamental, growing numbers of people in capitalist economies had engaging careers and were energised by their challenges and explorations. Capitalism was a godsend for them.

From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment. Frank Knight, observing US capitalism in his 1921 book, said that a company, in all of its decisions aside from the handful of routine ones, faces what is now called “Knightian uncertainty”. In an innovative economy there are not enough precedents to be able to estimate the probability of this or that outcome. John Maynard Keynes in 1936 insisted on the “precariousness” of much of the “knowledge” used to value an investment – thus the “flimsiness” of investors’ beliefs. (Yet now he is seen as “Smith plus psychological swings”.)

No coherent moral justification was ever suggested for throwing out a system providing invaluable and irreplaceable novelty, problem-solving and exploration, thus personal growth. On the contrary, humanist philosophy has continued since ancient times to hold up such experience as the “good life”. Socialists and corporatists never offered an alternative good life. They simply claimed that the system they advocated could out-do capitalism: wider prosperity, or more jobs, or greater job satisfaction. Unfortunately, there is still no wide understanding among the public of the benefits that can fairly be credited to capitalism and why these benefits have costs. This intellectual failure has left capitalism vulnerable to opponents and to ignorance within the system.

Capitalism lost much of its standing in the interwar period, when many countries in western continental Europe shifted to corporatist systems. This was a low point in the public’s grasp of political economy. In the end, the promises of greater prosperity and lesser swings could not be delivered. The nations that kept capitalism while making reforms, some good and others maybe not, ultimately performed well again – until now. Those that broke from capitalism were less innovative. After the disturbances of the 1970s, they saw unemployment rise far more than the capitalist nations did. They were worse on economic inclusion too.

Now capitalism is in the midst of its second crisis. An explanation offered is that the bankers, whatever they knew about capitalism, knew that to keep their jobs and their bonuses they would have to borrow more and more to lend more and more, in order to meet profit targets and hold up share prices. The implication was that the crisis flowed from a failure of corporate governance to curb bonuses and of regulation to rein in leveraging of bank capital to levels that made the banks vulnerable to a break in housing prices.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? The answer, I believe, is that they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down. The banks’ chief executives, too, had little grasp of uncertainty. Some had the instinct to buy insurance but did not see the uncertainty of the insurer’s solvency.

Much is dysfunctional in the US and the UK: a financial sector that turned away from the business sector, then caused its self-destruction, and a business sector beset by short-termism. If we still have our humanist values we will try to restructure these sectors to make capitalism work well again – to guard better against reckless disregard of uncertainty in the financial sector while reviving innovativeness in business. We will not close the door on systems that gave growing numbers rewarding lives.

The writer is director of the Center on Capitalism and Society, Columbia University, and winner of the 2006 Nobel Prize in Economics. To join the debate go to"

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