Chasing after zombies

It is hard to resist the inclination to exaggerate the importance of contemporary or recent economic events. Dramatic changes from the immediate past will often overshadow all but the greatest historical developments. Who nowadays, apart from specialists, discusses the Asian financial crisis of 1997-98? Or the Latin American debt crisis of the 1980s? Yet both were once seen as posing existential threats to the global financial system and endangering the world economy.

This tendency to exaggerate the historic importance of the present helps explain why so many experts are eager to declare that the world has entered a new era. There is the ‘new normal’ (Mohamed El-Erian and Bill Gross of Pimco, a global investment company), the ‘new paradigm’ (George Soros), and the ‘new capitalism’ (the BBC’s Robert Peston).

Anatole Kaletsky’s Capitalism 4.0 is different from most in that his new era embodies a positive vision. Most others foresee a period of low growth as well as high political and financial instability. In contrast, Kaletsky, the principal economics editor of The Times (London), sees the recent global crisis as an aberration. As long as policymakers are willing to be pragmatic, the future, he argues, should be bright.

The name of Kaletsky’s book comes from his identification of three eras of capitalism. Capitalism 1 ran from 1776 (the American Declaration of Independence and the publication of Adam Smith’s The Wealth of Nations) to 1931. Its philosophy was that of the free market, holding that economics and politics should be kept as distinct as possible. Capitalism 2, the Keynesian era of heavy state intervention, ran from 1931 to 1980. Most recent, running from 1980 until 2008, was the Capitalism 3 of free-market economics and the Thatcher-Reagan political revolution.

This attempt to look at capitalism from a long-term perspective is welcome. It is a refreshing change from the obsession with the present that characterises many of today’s economic commentators. Kaletsky’s distinctions between eras of capitalism are questionable – but at least he attempts to grapple with the complexities of the market economy.

Probably the most interesting part of the book is Kaletsky’s rebuttal to the orthodoxy that America suffered a massive housing bubble. He contends that the increase in house prices between 2000 and their peak in 2006 was modest in historical terms. It was more a recovery from an earlier 20-year slump than a true bubble.

To the extent global property prices were rising, it was, in his view, a rational response to benign trends. In particular, the Great Moderation – the unprecedented period of stability in the economy and labour market in the years running up to 2008 – made it easier for ordinary people to borrow. They had to worry less about losing their jobs than in the past and could expect rising prosperity.

Two other megatrends helped to bolster the long-term prognosis of the world economy. The addition of three billion people to the global economy – including those in China, India and the former Soviet Union – was a huge boon. In addition, globalisation meant that the principles of market competition, private enterprise and free trade were almost universally accepted.

Since these themes were central to Kaletsky’s optimistic outlook before 2008, he should not be accused of inconsistency. However, it could be argued that he is trying to justify his previous optimistic stance in the light of the subsequent crisis.

Kaletsky is less convincing in his explanation of the current crisis. He attributes much of the blame to Hank Paulson, the former US treasury secretary and head of Goldman Sachs, Wall Street’s most successful investment bank. Kaletsky portrays him as the epitome of what he calls ‘the total failure of leadership and judgement in the United States’.

For Kaletsky, the backdrop to Paulson’s colossal blunders was his attachment to ‘market fundamentalism’ – ‘a quasi-religious faith that markets are always right’. This narrow intellectual viewpoint led to the disastrous adoption of mark-to-market accounting and risk-weighted capital requirements. The first of these meant that banks assumed that the true value of their loans was that determined by the market. As a result, the regulator’s discretion was minimised. Together with risk-based capital regulation this had the effect of exaggerating the booms and busts in finance.

The second big blunder, also reflecting a market fundamentalist mentality, was the refusal by the US administration to intervene to stem surging oil and food prices. Although the spike was, in Kaletsky’s view, the result of speculation, still the authorities refused to intervene.

Most serious of all was the administration’s refusal to intervene in the financial system when the credit crunch began. Britain had shown what could be achieved by providing an open-ended guarantee to all domestic financial institutions to cushion the impact of the collapse of Northern Rock, a British mortgage lender, in 2007. Yet America had failed to take similar action following the collapse of Lehman Brothers, a Wall Street investment bank.

The main problem with Kaletsky’s work is that he exaggerates the influence of free-market thinking and practice. It is what is sometimes called a zombie category: one that goes on living even though it bears little relation to reality. Even in the economics faculties of American universities, true free marketeers were in a minority. And even if many did believe in a minimal state in principle, the reality was completely different.

Milton Friedman’s Free to Choose, the 1979 work that Kaletsky describes as the ‘intellectual bible’ of market fundamentalism, advocates a far more limited role for the state than existed in America in 2008. For Friedman, the role of government should include the three duties outlined by Adam Smith in 1776: protecting society from violence and invasion; administration of justice; and erecting and maintaining key public works. In addition, Friedman added a fourth duty of protecting members of society who cannot be regarded as ‘responsible’, such as children.

Whatever one thinks of this prescription, it bears no relationship to America on the verge of crisis. State spending accounted for about 37 per cent of GDP, and federal regulators such as the Federal Reserve and the Securities and Exchange Commission played an extensive role. The American authorities made mistakes but they were far more pragmatic than Kaletsky’s account allows. To the extent that they exacerbated the crisis, it was more to do with a reluctance to face their responsibilities than a doctrinaire allegiance to the free market.

Indeed, if there was an era of free-market capitalism, or Capitalism 1 in Kaletsky’s terminology, it ended in the late nineteenth century. Throughout the twentieth century, and into the twenty-first, the market economy has always depended on heavy state intervention of some type. Despite the bellicose free-market rhetoric of the late 1970s and early 1980s, the state never withdrew from everyday economic activity. It merely changed some of the ways in which it operated.

Kaletsky’s distinction between a fundamentalist Capitalism 3 and a pragmatic Capitalism 4 is also overdrawn. He comes nowhere near making a convincing case that the world entered a new economic era in 2008. The changes were far more incremental than he suggests.

The main challenge facing genuine critics of capitalism today is not to counter the marginal influence of ‘market fundamentalism’ or ‘neo-liberalism’. On the contrary, exaggerating the influence of free-market thinking means that the structural problems of the market economy are correspondingly underestimated. In particular, the sluggish dynamic towards economic growth in the West is seen as less of a problem.

Even worse, those who fixate on free marketeers fail to appreciate, let alone counter, the prevailing cultural aversion to prosperity. Economic growth is widely seen as destroying the environment, causing misery and fostering greed. Until such notions are challenged it will not be possible to make a positive case for affluence.

There is indeed a case to be made for a new economics. But it should embrace prosperity and identify the fundamental weaknesses of contemporary capitalism. Those who insist on chasing the zombie of free-market economics only reinforce confusion about the state of the world economy.

Daniel Ben-Ami is a journalist and author based in London. Visit his website here. His new book, Ferraris For All: In Defence of Economic Progress, is published by Policy Press. (Buy this book from Amazon(UK).)

An earlier version of this article appeared in Fund Strategy magazine.