The Credit Crisis, Socialism and Democracy

Dec 2008

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 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 asymetry. 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. Esentially 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 optimality has caused many modern economists to take an ideologically laissez-faire / anti-regulation approach. What that means is that their faith in assumed underlying principles caused them to turn away from empiricism and pragmatism. 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").

In fact, the problems of laissez-faire were apparent long before the credit crisis. We have long known that markets require intervention to ensure efficiency and competitiveness. For example, if manufacturers are to compete efficiently in the widget market the government needs to regulate what each participant can call a widget. Likewise heath and safety inspectors ensure restaurants don't cut corners in the kitchen. Without government taxation to finance investment in infrastructure, people could not turn up to work and companies could not move goods. In order to contain inflation Central Banks use monetary policy to manipulate the cost of capital. All these are vital modifications to the laissez-faire model. Although stricter banking regulation would have prevented the credit crisis, many believe this crisis is nevertheless teaching us that our capitalist model is much more deeply flawed that we had previously believed. In essence the crisis is a wake up call reminding us how absurd laissez-faire ideology is.

Martin Wolf talks about the two opposing ideological visions which have dominated political debate - socialism & capitalism. The socialist model removed individual freedoms in order to enforce equality. We now know that competition and incentive are vital drivers of economic growth and human happiness, and removing them in order to ensure equality proved disastrous. The capitalist model protected individual freedoms which consequently allowed inequality and encouraged competition. Economists cite Smith's invisible hand argument as one justification, democrats cite the moral principle of free will as another. Yet the invisible hand is flawed, and pure free will has various problems including social justice.

Now a third model is emerging, especially from the ashes of socialism, and today it is popular in China, Singapore, Dubai etc. The third model allows individual freedom and inequality where it encourages competition (as capitalism), but also removes individual freedoms wherever it is perceived to benefit the greater good (as socialism). Although the government is interventionist, the third models differs from classic democratic socialism because the driving force of the interventionist policy is the promotion of economic growth, not the soft humanitarian aims of socialism. An example is forcibly moving 1.4 million people to build the worlds largest hydroelectric plant. Third model is not ideological, its proponents are pragmatists, utilitarians and rationalists. In a sense, the primary essence it takes from socialism is compulsion, and from capitalism competition.

So the Credit Crisis is discrediting capitalism, but it is not reviving socialism. Rather it is championing this third way. In the 1970 angry socialists clashed with capitalists. The socialists denounced the capitalists as inhumane, but the capitalists proved that socialist equality is inefficient. Now the utilitarians are proving that the individual liberties of capitalism are inefficient. The capitalists are defending their position with increasing rancour as the case against them builds. At its most extreme we have the "goldbugs" who claim the crisis not a failure of capitalism so much as government control of the money supply, and all we need to do is abolish the FED and adopt the gold standard. Once the capitalists were denounced as inhumane, now they denounce the utilitarians as inhumane, and Churches increasingly take up the cause.

The triumph of the third way is clearly a powerful challenge to democracy. China, Singapore, Dubai, Russia are third way proponents and undemocratic. Not only are democracy and individual liberty closely entwined, democracy is the politics of personal gain not social utility.

In 2009 all the major developed nations are expected to be in recession and all world growth will be produced in the emerging world, especially China. I believe what we are seeing is the beginning of the end of democracy. The pendulum has swung- we are replaying the seminal moments of history summed up by the 430BC Pelopensian War fought between the rich but self centred democracy of Athens, and the brave self sacrificing autocracy of Sparta. At the end of that war Athens was utterly subjugated and democracy extinguished.

I believe we have reached the end of an era, the next belongs to China and authoritarianism, and in years to come when we look back and compare the economic achievements of the two the contrast will be as extraordinary as it was between the Romans and the Greeks. In Ancient Greece politics divided not into socialism-capitalism but rather authoritarianism-democracy. In years to come I believe we will see this re-emerge, and, just as in Ancient Greece, the intellectuals will generally be on the side of authoritarianism.