Credit Crisis Lessons: Capitalism, Socialism, Democracy

December 2008, Part II rewritten Jan 2013

Part I: Credit Crisis Lessons: Economic Theory

Reading Martin Wolf and the other commentators over at the Financial Times one can not but be impressed by scale of ideological revaluation now taking place with regards to the efficiency of the market economy. For example, in his article Keynes offers us the best way to think about the financial crisis Wolf writes that we have learned three critical lessons:

(1) The first lesson, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”.

(2) The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company it now makes sense to cut costs, but if the world does so simultaneously it will merely shrink demand. [What is optimal for the individual is not optimal for the world at large]

(3) The third and most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

I can rewrite these points as follows:

(1) The hypothesis of rational expectations and efficient markets is far weaker that we had imagined. A famous example of poor quality pricing occurs in the private market for second hand cars as a result of information asymmetry. If I sell you my old car I probably know far more about its value that you do, yet I will not truthfully pass that information onto you, because capitalism is motivated only by the maximization of personal gain, so rational capitalists have no morality, all goodness must be forced upon them by regulations/contracts/self-interest. What sort of regulation can improve pricing in this example? The seller feedback ratings on the auction site eBay.com help a little.

(2) The 'invisible hand' optimality hypothesis is far weaker that we had imagined. The invisible hand is a metaphor coined by the economist Adam Smith. Smith argued that, in a free market, an individual pursuing his own self-interest tends to also promote the good of his community as a whole through a principle that he called “the invisible hand”. He argued that each individual maximizing revenue for himself maximizes the total revenue of society as a whole, as this is identical with the sum total of individual revenues. Mathematically this argument is non-sense - think about chess - good chess is not about optimizing the outcome of individual pieces.

The failing of rational expectations and invisible hand in the market for derivatives was largely responsible for the credit crisis. The banks knew many of the complex products they were selling were inappropriate. Smart commentators such as Warren Buffet described credit derivatives as weapons of mass destruction long before the crisis began. Regulators in many countries including China banned them. Even potentially useful derivatives have a cost which end users rarely understand, banks like to make 20% returns on capital, they take huge profit margins which erode the benefits of derivatives. Again Warren Buffet understood this, and he consequently encouraged his companies to avoid all derivatives. Essentially the banks did not publish all pertinent data on their products to their clients, nor did they take all reasonable steps to ensure their clients were behaving rationally, so the self-interest of the banks did not promote the good of the community.

(3) The erroneous assumption of rationality and invisible hand justified a politically attractive ideologically laissez-faire approach to economic science. Economists began treating these principles as articles of faith, and turned a blind eye to empirical and pragmatic criticism. In doing so they violated the most important Keynesian lesson, economics is not a morality play, it must be treated as an applied science, its theories must be justified by statistical studies. Keynes also said economics is a complex system, a messy subject which necessitates a degree of imprecision (famous quote: "It is better to be roughly right than precisely wrong"), and complex systems defy dogma.

Of course, the problems of laissez-faire were well know long before the credit crisis. Both the founding fathers of right wing economics, namely Adam Smith and Friedrich Hayek, talked about the madness of stretching laissez-faire dogma too far. We stopped calculating and became bozos who started applying our economic instincts to the canvas without measure and harmony and perfectionism. Sometimes the bozo is slavish, by which I mean very ideologically rigid, sometimes drunken, by which I mean someone who is wavering back and forth, sometimes illiberal, by which I mean unable to detach from self interest.


Part II: Credit Crisis Lessons: Political Theory

Socialism & Capitalism as a balance of power between workers and bosses

Martin Wolf's article talks about the two opposing ideological visions which dominate political debate, namely socialism & capitalism, and he says we are making a mistake by turning everything into a morality play instead of thinking about life more practically. But how do we actually define the morality play everyone calls "socialism" and "capitalism"? Reading between the lines Wolf seems to suggest a definition involving "individual self-seeking" on the right hand side, but let's follow Adam Smith's original idea in the Wealth Of Nations, which was so memorably portrayed in Fritz Lang's 1927 film Metropolis, and say that:

Socialism and capitalism grew up out of the relationship between the workers and the bosses, the socialists typically think the problems of the world are caused by greed in the bosses, and the capitalists typically think the problems of the world are caused by feckless workers. Therefore when people argue whether or not we need more socialism or more capitalism in the world, they are arguing about the balance of power between the workers and bosses. When the relationship looses its measured harmony economic crises and political revolutions occur.

Wise men might complain this definition is hopelessly shallow and even totally upside down, but I think it's good enough for this article. So let's begin by putting the theory into practice with an analysis of the last big cyclical change in modern history, namely the transition from the Post Keynesian Consensus to current Capitalistic era pioneered by Margaret Thatcher and Ronal Regan in the early 1980s.

I like to date the Post Keynesian Consensus as beginning in 1946 with the nationalization of the Bank Of England, and ending in 1981 with the privatization of British Aerospace and Cable & Wireless. In 1957 the newly elected British Prime Minister Harold Macmillan famously said "people have never had it so good". Certainly those first twelve years of the Post Keynesian Consensus were very much a golden era of economic growth and quality of life improvements, and not just in the UK but indeed right across the Western World. When British Prime Minister Harold Wilson made his famous 1964 speech saying "the Britain that is going to be forged in the white heat of this [technological] revolution will be no place for restrictive practices or for outdated measures on either side of industry" he was fighting a political battle to restore the sort of technocratic spirit associated with the earlier years, and which had grown out of the pioneering scientific spirit and communal idealism of the Second World War. Unfortunately it was battle he didn't win.

By the early 1970s the Post Keynesian Consensus began seriously unravelling with oil price shocks and inflation and industrial unrest and competition with Japan. The energy crisis had it's roots in short term thinking, the inflation crisis in uncontrolled government spending, and industrial unrest in the general loss of social cohesion and anarchistic spirit of the times. By 1976 the state owned enterprises that had pioneered growth in the 1950s were loosing money and the British government was in such dire financial straits it needed an IMF program. The hard working post war spirit had given way to the sort of workplace culture we associate with the modern UK Post Office, eg strict 9-5 working hours with tea breaks, closed shop practices etc. Also strategic reforms to the economic model were blocked. Think, for example, about the coal miners. Globalization, particularly Japanese competition, had made UK coal a totally inefficient way to power the economy, but the workers weren't prepared to let the coal mines close, they wanted inefficient state owned enterprises to keep going no matter what.

In the 1980s Margaret Thatcher responded to these 1970s problems by shrinking the state, privatizing state owned enterprises, leaving as much as possible to the market. Realise that, in a sense, the workers are the communal one and the bosses are the individual many, so like the old divide and conquer strategy her actions vastly weakened the left by diluting the power of both trade unions and elected politicians to interfere in the economy. In other words, Thatcher's revolution was like a landside that dramatically shifted the balance of power away from the workers back to the bosses. As working conditions tightened up and inefficient industries closed, the economy started picking up speed and the UK went on gaining in strength, at least on paper, up until 2006/2007.

The financial crisis and the balance of power

Our balance of power argument reminds me of a story I heard about seals that swim in the sea. Apparently all the seals we see lying on beachs are females and cubs, adult male seals don't leave the water. Each beach is controlled by a single adult male, and he spends his entire time swimming around making love to the females and fighting off any males who come close. He is so engrossed in this great work that he doesn't even eat, and as a result he gradually looses his strength, and one day another male seal who has been living all alone in the ocean will defeat him and take over the beach. At that point the cycle starts again, the seal that has won control of the beach stops eating, and the seal that has lost control swims out to the ocean and starts eating again, building back his strength until he can find another beach to conquer.

In the same sort of way we can imagine history as pendulum that swings back and forth, or perhaps a tug of war between two teams, and whichever side wins starts off well but gradually deteriorates, opening the way for another power shift. The example we gave seems to describe this very scenario, during the Post Keynesian Consensus the workers were in ascendancy, and from 1946 to 1957 they were led by brilliant white hot scientists, but it gradually went downhill starting with softie drinkers in the 1960s, finally culminating with complete ideological zombies such as Neil Kinnock and Arthur Scargill. At that point the tough guy Margaret Thatcher came along and chased them all a way and hoisted the bosses flag over the castle. For a while we all rowed for Britain like troopers, but as soon as things started getting comfortable softies and drinkers took over the show and gradually ran it all back into the ground, and now we are like the Princess in the Tower praying for a workers White Knight to came and rescue us from the unworthy bosses who seduced us with magic spells and now keep us prisoner behind thick walls.

Yet history is a bit more complicated that this, and to understand that think about something Tony Blair said in his biography:

"I profoundly disagree with the statist response to the economic crisis... [The financial crisis has] led progressive politicians, on the left especially, to assert that politics is undergoing a radical shift of direction towards a more interventionist statist position... the end of an era that began over thirty years ago with the Thatcher/Regan economic and political philosophy...  [I reject this and] funnily enough, the public has got this more than many politicians and commentators, which is why a great lurch leftwards has not materialised. The public understands completely the difference between the state being forced to intervene to stabilize the market, and the government back in fashion as a major actor in the general economy. The role of the government is to stabilize and then get out of the way as quickly as is economically sensible. Ultimately the recovery will be led not by governments but by industry, business and the creativity, ingenuity and enterprise of people. If the measures you take in responding to the crisis diminish their incentives, curb their entrepreneurship, make them feel unsure about the climate in which they are working, then recovery becomes uncertain... What should strengthen this belief is that the new economies now rising up in the marketplace are doing so precisely by following more open economic policies, and faltering when they don't. China is opening up, and thrives as it does so... It would be odd if we moved in the opposite direction. And foolish."

What that quote brings home to us is that even though Tony Blair was on the side of the workers not the bosses, the way in which he tried to help the workers was very different from the post war technocratic technologists who rebuilt Britain after the war. Tony Blair didn't question economic liberalism, he believed the economy should be left alone and the profits simply milked for social projects, in other words he found a way to make the two sides one. It's very important to understand this point:

Imagine a debate between an elite Catholic and a down to earth Puritan, you would think the two positions are antithetical and must constantly be at war with one another, but in fact they can and do combine regularly. Think, for example, about Andy Warhol, do you see he sort of managed to be both elitist and populist at the same time? Philosophical opposites can mix and produce a third, likewise opposites can both go out of fashion and leave the way for a third power to take over. 

Understand that this is the situation we are in today. The crisis is not just about greedy bosses triumphing over lazy workers, or lazy workers triumphing over greedy bosses, in a sense it is about both at the same time. For example, Club Med is famous for overpaid rigid labour markets, do you see this is a problem on the left hand side? For example, America is famous for companies like Microsoft earning monopoly profits selling rubbishy products and avoiding taxes with offshore structures, do you see this is a problem on the right hand side?

For over a decade the golden rule of politics has been "find the centre ground" and "be all things to all men", the two have become in a sense one, and now the one is cracking apart just as it did in the mid 1930s. In the 1930s the power moved to the extremes, and the extremes started looking like a one, so the Fascists and Communists were hard to tell apart. This is what the birth of a new paradigm looks like, and if you think about it carefully the Fascists and Communists were twins, the first romantics and the second utilitarians, but the baby was deranged and had to be put down. In fact, if you think about it two sets of twin births took place during the carnage of the 30s and 40s, one was to an extent the enlightened absolutism of the Post Keynesian Consensus, and the other the tyranny of Fascism/Communism.

Of course nobody watching modern China would be surprised by the idea that it's not about left or right but rather something entirely new. On the one hand the Chinese forcibly move 1.4 million ordinary people out of their homes to build the worlds largest hydroelectric plant, and on the other hand the financial system is dominated by state owned banks that run returns on capital and executive compensation schemes that Western shareholders and CEOs wouldn't get out of bed for. The first is a sort of anti-socialist flogging of the workers, and the second a sort of anti-capitalist fleecing of the bosses.

Why is it so confusing? The problem is that the crowd analyses the crisis by juggling in their mind words such as "socialism" and "capitalism" but without anyone really knowing what these words are supposed to mean. They are in fact nebulous and constantly evolving psychological profiles, and philosophy is the art of identifying them and juggling with them. But it's not really an art that people in general need to learn, because the real hands on experts don't think in these kinds of terms, because they are pragmatically solving problems. For example, the coal mines needed to close back in the 1970s simply because they were inefficient, not because of abstract philosophical arguments about the balance of power between bosses and workers.

So philosophy is a dangerous art that encourages us to ignore Keynes' advice and turn economics into a morality play. What then is philosophy for? It's for teaching and debating ethics and self development. I don't want to say that philosophy is for political debate, because that will turn everyone into circus loving hippies instead of experts.

Let's give an example of the way in which philosophy can help us learn about ethics and self development. Martin Wolf mentioned self interest in his article. What do the 1970s socialists and the 00s capitalists have in common? They are both wallowing in self interest right? The trade unionists destroyed the 1970s economy by insisting on ossified working conditions and outmoded industries such as coal mining- killing the goose that lays their golden egg. The capitalists destroyed the 00s economy by selling everyone junk financial products and gambling greedily-  killing the goose that lays their golden egg.

What comes next? If a society faces up to its flaws and looses its ignorance an enlightened new paradigm is born, if it fails another monster springs up. Either way everything we knew disappears, but in the first case the mood has the positive energy of Indiana Jones in the 1981 film "Raiders of the Lost Ark", and in the second case the mood has the negative energy of the scared faced Nazis he was competing against.