Is Capitalism Broken?

What we have in America is socialism for the rich and capitalism for the poor.

~ Gore Vidal

Update: This article is included in the Carnival of Financial Planning #138. Thanks!

In the inaugural installment of this series on capitalism, we introduced Capitalism’s 3 Children: owners, managers, and employees. All of them have key roles to play in the success of our economy. But, like any group of siblings, they tend to jockey for attention and frequently squabble among themselves.

Is Capitalism Doing Fine, Fundamentally Flawed, or Broken?

When the financial crisis and ensuing recession hit, we heard a lot of people blaming the capitalist system for the problems. So today we’re asking: Is capitalism broken? It seems to me that there are 3 main camps, each of which would answer that question differently:

1. No. There’s nothing wrong with capitalism. Sure, we had some problems in the banking system and the resulting recession hasn’t been fun, but things are improving now. Have you seen the stock market over the past year? These cycles are just a normal part of capitalism.
2. No. Capitalism is not broken. It’s fundamentally flawed. It can’t work because it’s not a viable economic model in the first place. Human nature dictates that corruption and greed will taint any system that allows people to function with limited regulation. Left to our own devices, we will always look out for number one.
3. Yes. Capitalism can work, but we’ve broken it. We’re not doing it right. Gore Vidal was right. The owners love capitalism when it works in their favour, but when it comes time to pay the price for risk-taking, they want to pass that off to taxpayers.

It seems to me that each of these arguments has some merit, but I have to say that I sympathize most with the “yes” camp. I do think capitalism can work, but that it definitely needs some improvement. While I do agree with Vidal to some extent, I don’t think that the owners are the only child of capitalism to blame for our problems. I’ll get into more detail on that in a future installment.

Why Capitalism Fails

Why Capitalism Fails was the title of an article in the Boston Globe last year that outlined the views of Hyman Minsky. He was an economist who received very little acclaim during his life for his writings, but has since become a bit of an economic rock star. (Is that an oxymoron?)

Minsky’s views, while largely ignored in his day, have come to prominence with the advent of another economic crisis. Ever heard of a Minsky moment? That’s basically a term coined by Paul McCulley of PIMCO to describe the climactic crisis that results from extended periods of economic stability.

It was Minsky’s contention that our capitalist system creates long periods of time that appear stable and prosperous, but that the seeds for instability and depression are sown at the same time. When I asked How Did We Get Here?, I wrote about the cyclical tendencies of human nature and economics. The quote that opened my recent post on 6 Life Lessons from the Stock Market captures this idea pretty well too. No trend is infinite. The pendulum keeps swinging. You get the idea.

The Financial Instability Hypothesis

Basically Minsky’s cycle, the Financial Instability Hypothesis, goes something like this:

• After a depression, financial institutions, businesses and consumers become very cautious about borrowing, lending, and spending.
• Fiscal prudence leads to economic prosperity.
• Economic prosperity leads to complacency. As time passes, people forget the lessons of the depression.
• Lending standards become lax and eventually “Ponzi borrowers” carry so much debt that they can only cover their expenses by borrowing more. (There are a lot of countries as well as individuals in this position right now.)
• The success of the economy is no longer dependent on sound business practices, but on the ability to access cheap credit. (Is any of this ringing a bell?)
• Once the economy reaches this point, any small event could trigger an economic avalanche. The exit door is simply too small to get everyone out on time.

The latter tipping point is the Minsky moment. That is the point at which the house of cards collapses. Minsky died in 1996, having spent a great deal of time warning about the potential house of cards that was securitization, financial innovation, and excessive leverage. No one listened.

Although he did seem to think of capitalism as fundamentally flawed to some extent, (a camp #2 view), Minsky also fits into camp #1. He believed that periods of stability leading to periods of instability was just part of capitalism. But Minsky, like John Maynard Keynes, felt that the government or the central bank could ameliorate the consequences of the inevitable economic crisis by intervening to become the employer or lender of last resort respectively. If you want to read more about this, read the Boston Globe article referenced above. It’s pretty interesting.

An Ounce of Prevention Is Worth a Pound of Cure

O.K.. So I’m not an economist, and I know this might sound naive, but . . . If we know this cycle exists, wouldn’t it be better to put our efforts into preventing the collapse rather than repeatedly dealing with the same consequences over and over again à la Homer Simpson? Surely a civilization that has travelled to space and decoded the human genome can figure out a way to keep the economy on an even keel. Is human nature so immutable that we cannot self-correct?

The response to this most recent Minsky moment has been distinctly Keynesian. The global central banks have dumped money all over this problem, whether they actually had the money or not. Wait. Isn’t that how we got here?

Do you think capitalism is broken?