When the twin crises erupted on Wall Street and Main Street, each one of them fierce in itself but far more frightening when they interacted, populists rushed forward to celebrate the demise of capitalism and, for added gratification, plunge their pitchforks into its dead corpse. Since then, they have had their champagne parties. By now, however, the fizz is gone and the rush to judgment by capitalism’s obituarists has left us with tattered myths and egregious fallacies that invite scrutiny and refutation.
I can do no better than begin by citing a prominent populist, an icon to the madding crowd who would like to drive a stake through capitalism and globalization (which is viewed, not without some justification, as an international extension of capitalism). I am speaking of my Columbia University colleague Joseph E. Stiglitz. In 2001 he shared the Nobel Prize in Economics with the remarkable George Akerlof of Berkeley, who pioneered the study of asymmetric information with his brilliant paper on “the market for lemons,” the first to draw on the insight that the sellers of used cars (i.e., lemons) had more information than the buyers, a situation that would generally lead to “market failure.” In the long sweep of market failures, with virtually every generation since Adam Smith’s focusing on a different one appropriate to its time, asymmetric information is just one more, of course, and not even among the most important, it could be argued.
But Stiglitz made a much-cited claim that the current crisis was for capitalism (and markets) the equivalent of the collapse of the Berlin Wall. Now, we know that all analogies are imperfect, but this one is particularly dicey. When the Berlin Wall collapsed, we saw the bankruptcy of both authoritarian politics and an economics of extensive, almost universal, ownership of the means of production and central planning. We saw a wasteland. When Wall Street and Main Street were shaken by crisis, however, we witnessed merely a pause in prosperity, not a devastation of it.
We had enjoyed almost two decades in which the liberal reforms undertaken by China and India, with nearly half the world’s population between them, had produced an unprecedented prosperity that (and this must be emphasized) had finally made a significant impact on poverty, just as we reformers had asserted that it would. The rich countries, with a steady expansion of liberal policies during the 1950s and 1960s, had also registered substantial prosperity. (This was episodically interrupted by exogenous circumstances like the success of OPEC in 1971 and the Volcker-led purging of the 1980s, but generally always resumed with robust growth.) Meanwhile, an increasing number of the poor countries had turned to democracy, altering the status quo ante in which India had been the one “exceptional nation” to have embraced and retained democracy after independence.
Some will object that economies have at times registered high growth rates for long periods despite bad economic policies. But we must ask: are such growth rates sustainable? I tell the story about how my radical Cambridge teacher, Joan Robinson, was once observed many years ago agreeing with the mainstream Yale developmental economist Gus Ranis on the subject of Korea’s phenomenal growth. The paradox was resolved when it turned out that she was talking about North Korea and he about South Korea. Now, more than three decades later, we know who was right. In a similar vein, Soviet growth rates were high for a long period, thanks to exceptionally high investment rates and despite the horrendous absence of incentives and embrace of autarky. But then the Soviet Union descended into a steady decline until a mismanaged transition with perestroika plunged the country into negative growth rates.
The effort to make the anomalous into the universal is a polemical exercise. Some economists, such as Dani Rodrik, like to cite occasional high growth rates in countries without liberal—or, as some critics prefer because it sounds more sinister, “neoliberal”—policies as a refutation of liberal policies. This, however, misses both the point of the issue and the sweep of history.
Other critics then shift ground, claiming that higher growth is beside the point and that we need to judge capitalism by whether it works for the poor. But slowly growing or stagnant economies cannot rescue the poor from their poverty on a sustained basis. In countries with massive poverty, such as India and China, economic success has had to come principally through rapid growth of incomes and jobs. This is, of course, common sense. Just as firms that make losses cannot finance corporate social responsibility policies, countries with stagnant economic performance cannot rescue the poor from their poverty.
It was bad policy that kept China and India from growing in the first place. Only after liberal economic reforms did these countries register accelerated growth rates that, during the last 20 years, finally pulled nearly 500 million people above the poverty line. However grim the current crisis has been, it cannot be used to deny this elemental truth.
Arguing the other side of the coin, the AFL-CIO and other labor unions in the United States claim that trade with poor countries has produced paupers in the richer countries by depressing real wages. But this dire conclusion is not supported by empirical findings. My own analysis, dating back at least a decade (and extended in my 2004 book, In Defense of Globalization), argued that, if anything, the fall in wages which labor-saving technical change and other domestic institutional factors would inevitably have brought about was actually moderated by trade with poor countries. This benign conclusion has since been reasserted by Robert Lawrence of Harvard’s Kennedy School (despite an unsuccessful attempt by Paul Krugman in a recent Brookings paper, commissioned by Lawrence Summers, to prove otherwise). Indeed, the same goes for the effect of unskilled immigration on the wages of our unskilled workers. Giovanni Peri of U.C. Davis has shown for unskilled immigration what I showed for trade with poor countries: that the effect is benign.
Thus, we need not apologize for liberal policy in terms of its effects on overall prosperity, on poverty in poor countries, or on the wages of the poor in rich countries. To compare an interruption of this remarkable progress to the
collapse of the Berlin Wall is like drawing a parallel between a tsunami and a summer storm that brings rain and a rich harvest to parched plains.
These critics, including Stiglitz and, ironically, George Soros (who has done rather well by working the markets), also argue that the current crisis spells the end of “market fundamentalism.” My Swedish friend Leif Pagrotsky, who was a cabinet member in Prime Minister Goran Persson’s government and is on the left in his country’s Social Democratic Party, told me with amused astonishment that at a panel meeting at Columbia University in New York, Soros had accused him of exactly this sin. “Market fundamentalism” has now become a phrase of scorn in these fringe populist circles, much like “liberal” is in the fringe right-wing circles.
The presumption from which these critics start is that our markets were based in a pragmatic center but then moved to the fundamental right, letting markets rip—and rip us apart. But this is totally wrong for much of the world, and certainly for many developing countries that had been mired in quite the opposite problem, an anti-market fundamentalism that was reflexively and irrationally hostile toward markets and reliant on knee-jerk interventionism that went so far that Adam Smith’s invisible hand was not only not seen but never felt. When these countries finally realized the costs of their anti-market fundamentalism, they moved to the pragmatic center. So, yes, there has been a shift in recent years, but it has not been from pragmatism to market fundamentalism, as critics such as Stiglitz and Soros would have us believe, but from anti-market fundamentalism to the center.
A myth related to those above is the notion that somehow there was a consensus in Washington among the Bretton Woods institutions that drove the world into liberal reforms, which evolved into a malignant market fundamentalism. But anyone familiar with the measures undertaken with gusto in the Soviet Union (and then Russia), India, and China, which together claim a gigantic share of the world population, has to know that these measures were endogenous, not imposed from without. The reformers in all of these countries were not bullied into submission, but driven by their increased awareness that without these liberal reforms their societies would continue to stagnate.
The precise mix of politics, institutions, and history did matter in the specific trajectory of reforms chosen. In my Radhakrishnan Lectures at Oxford in 1993, I discussed the factors driving Indian reforms, which began in earnest in 1991 with the current prime minister, who was then the finance minister, leading the way. These included the fact that the reforms became inevitable as the dissonance grew between India’s superiority complex about its “ancient culture” and the “inferior status” that its sorry economic performance had wrought. And as for the former USSR, the Russia expert Padma Desai has written that Mikhail Gorbachev and Eduard Shevardnadze finally decided that, without reforms, Soviet decline would continue to get worse and their superpower would be reduced to the size and influence of a super beggar in world politics.
None of these reformers cared about what Bretton Woods institutions, or Washington more generally, thought. The idea of a “Washington consensus” is little more than a Washington conceit developed by witless Western media and spread by anti-globalizationists and critics of capitalism, who find that the anti-Americanism this phrase invokes gets their critique greater mileage than its content actually merits.
Inevitably, the crisis on Wall Street has revived the never-ending notion that markets undermine morality. Oliver Stone, ever restless to recapture the days of former glory, has begun production on a sequel to the 1987 movie Wall Street, which immortalized Gordon Gekko as the symbol of markets and greed. But the debate on how markets affect morality has not always been a slam dunk for capitalism’s naysayers. Matthew Arnold, especially in his influential 1868 book, Culture and Anarchy, might have been spectacularly critical, but Voltaire’s passionate defense of markets, most eloquently stated in his 1734 Philosophical Letters, made him the most influential hero of the new bourgeois age. He proposed quite reasonably that peace and social harmony, as opposed to the religious strife common until then, would flow from the secular religion of the marketplace.
After two and a half centuries of this fascinating debate, I have to say that my own sympathies lie with those who have found markets, on balance, to be on the side of the angels. But I should also add that I find the specific notion that markets corrupt our morals, and determine our ethical destiny, to be a vulgar quasi-Marxist notion about as convincing as that other vulgar notion that
ownership of the means of production is critical to our economic destiny. The idea that working with and within markets fuels our pursuit of self-interest, greed, avarice, and self-love, in ascending orders of moral turpitude, is surely at variance with what we know about ourselves.
Yes, markets will influence values. But, far more important, the values we develop will affect in several ways how we behave in the marketplace. Consider just the fact that different cultures exhibit different forms of capitalism. The Dutch burghers Simon Schama wrote about in The Embarrassment of Riches used their wealth to address the embarrassment of poverty. They, the Jains of Gujerat (from whom Mahatma Gandhi surely drew inspiration), and the followers of John Calvin were all taking values from religion and culture to bring morality to the market. Many economists, perhaps most noticeably André Sapir of Brussels, have used their study of the diverse forms of capitalism that flourish in the world to deny the claim that markets determine what we value. The Scandinavians, for example, have an egalitarian approach to their capitalism, which differs from what we find in the United States, where equality of access, rather than of success, is the norm.
So, where do we get our values? They come from our families, communities, schools, churches, and indeed from our religion and literature. My own exposure to the conflicts of absolute values came initially from reading Dostoevsky’s Crime and Punishment, wherein Sofya Semyonovna Marmeladov turns to prostitution to support her family. My love of the environment came from reading Yasunari Kawabata’s famous novel, The Old Capital, which purports a harmony between man and nature, rather than the traditional Christian belief that nature must serve man.
How does one react then to a phenomenon like Bernie Madoff? Does it not represent the corrosion of moral values in the marketplace? Not quite. The payoffs from corner-cutting, indeed outright theft, have been so huge in the financial sector that those who are crooked are naturally drawn to such scheming. The financial markets did not produce Madoff’s crookedness; Madoff was almost certainly depraved to begin with. The financial sector corrupts morality in the same sense that the existence of an escort service corrupted Eliot Spitzer. Should we blame the governor’s transgressions on the call girls rather than on his own flaws?
Something more needs to be said about the notion that, at least in the financial sector where the collapse began, it was the ideology of markets and deregulation rather than factors such as lobbying by Wall Street to make profits that drove the crisis. That proposition is simplistic and therefore wrong.
Of course, the notion that freer financial markets and increased reliance on self-regulation would help the greater good played a role in what happened. The postwar period had shown, as noted above, the powerful effect of liberal economic policies on trade and direct foreign investment. But to carry over the legitimate approbation of freer trade in particular to the altogether more volatile financial sector, which represents the soft underbelly of capitalism, was surely unwarranted.
Pressure from the IMF and the U.S. Treasury on developing countries to embrace capital account convertibility (i.e., free capital flows, so one could walk into a bank and convert limitless domestic currency into whatever foreign currencies one chose) had been palpable, and was indeed a principal cause of the East Asian financial crisis in the late 1990s.
We must ask why some of the world’s best economists, such as Larry Summers, went along with the assumption that the indisputable advantages of freer global trade would extend into the financial sector, when in fact they had to be aware of the asymmetry. Their blind spot was caused by what I called the Wall Street-Treasury Complex. The constant movement of people like Robert Rubin and lesser but still influential figures between Wall Street and the Treasury Department created a euphoria—shared by a large group of influential people who sport Brooks Brothers suits, belong to the same clubs, and travel on the same circuits—about how markets that would serve the interests of Wall Street would function just as well in the financial sector as in trade. This euphoria led these gifted economists at Treasury and the IMF to drop their guard and join in the chorus for freeing up capital flows.
Furthermore, we should not underestimate the role that good old-fashioned lobbying played in the crisis. One of the seminal moments occurred when the heads of the big five investment banks, among them future Treasury Secretary Hank Paulson (then CEO of Goldman Sachs), “persuaded” the SEC to impose no reserve requirements on their lending. The result was reckless over-leveraging that accentuated the crisis when the housing bubble burst and securitized mortgages became toxic assets. But this had to do more with lobbying for profit than with ideology. An ardent environmentalist and graduate of liberal-leaning Dartmouth College, Paulson was surely no ideologue on markets, the way Alan Greenspan, outspoken fan of Ayn Rand, had been during his time as Fed chair.
But why did the SEC agree to this demand? Answering this question takes us right into the role played by governmental failure, not “market fundamentalism,” in creating the crisis. Senator Chuck Schumer, whose Wall Street PAC contributors come with his political territory, is known for having indulged in Japan-bashing, then India-bashing, and now China-bashing. This time around, though, he bought into the argument that Wall Street would lose out to London if the demands of the investment banks were not met. So, he played a crucial role in the “race to the bottom” that was central to the crisis.
The governmental role in the crisis was also apparent in the way in which congressmen of both parties bought into the argument that everyone, regardless of individual circumstance, must own a home, thus encouraging the profligate spread of subprime mortgages that inflated the housing bubble with what would become toxic assets. Instead of creating a house-owning democracy, these fantasies created an inevitable crash that imperiled the economy.
Columbia Law School Professor Harvey J. Goldschmid, who served as an SEC commissioner, has talked about the plethora of mortgages hawked by unscrupulous, unqualified agents whose sleazy courtship of naive clients largely replaced the conventional, careful evaluation of servicing ability of prospective home buyers by small bankers: it was as if you were traveling in planes flown by untrained pilots and owned by profit-seeking airlines that sold seats to people who could hardly afford subway fare.
The packaging of these subprime mortgages into collateralized debt obligations called mortgage-backed securities (MBS) was married to the credit default swaps (CDS) invented by J. P. Morgan bankers, which got third parties like insurance giant AIG to assume the risk of default on these securities in exchange for regular payments resembling insurance premiums. The MBS were expanded massively because it was assumed that the risk of default in the underlying mortgages was minimal because not everyone would default together. The massive exposure created by those who blithely issued CDS but did not set aside adequate reserves to guard against a possible financial tsunami guaranteed the collapse of the financial sector.
In short, few on Wall Street caught up in the euphoria over these financial innovations allowed for the reality of huge potential downsides that should have required prudence and safeguards. All economists and policymakers know about what Joseph Schumpeter called the “creative destruction” of capitalism, but the invention of these new financial instruments had a wholly different downside possibility, one capable of bringing about what I have called—and journalists such as Gillian Tett and Thomas L. Friedman have since called—“destructive creation.”
This potential requires that innovation in the financial sector be dealt with differently than other innovation. I have therefore argued that we need an independent set of experts, who are familiar with Wall Street but are not part of it (or of the Wall Street-Treasury Complex), to evaluate the downside of new instruments, and to make that informed analysis available to regulators, who, after all, cannot regulate what they cannot understand.
Such a committee would not necessarily solve all problems lurking in our economic future. As Keynes once remarked in a letter to Kingsley Martin, editor of the New Statesman, “The inevitable never happens. It is the unexpected always.” But such a committee, which in different versions is part of the new financial regulatory architecture now being discussed, might be able to make the unexpected a little less inevitable.
Need I argue further that the notion of capitalism as a collapsed system requiring invasive surgery is far from compelling? I hope not. But one observation must be made regarding what exactly needs to be done to strengthen capitalism today.
Capitalism works best when those who do not succeed, and are buffeted by the vicissitudes of life, still believe in success—believe that those who do succeed put their wealth to good use, and do not merely engage in self-indulgence. Remember that the Calvinists and the Jains of Gujerat accumulated wealth but spent it not on themselves but on promoting social good.
Capitalism works well when those who lose feel that one day they might also win. This is the great American dream: even when mobility has been less real than imagined, the belief matters.
Today, in the United States, both “stabilizers” of capitalism have taken a hit. There has been far too much flaunting of wealth, even as working-class incomes have stagnated, with magazines on “How to Spend It” in the Financial Times and displays of the insufferably rich glitterati in the Style section of the New York Times. These are among the countless examples of a compliant, complacent, profit-seeking media establishment giving such displays wider circulation even as they occasionally condemn the return of the Gilded Age.
CEOs in the manufacturing sector hit a nerve when they were seen cashing in stock options as their firms were failing, leaving their workers and shareholders with defunct stock options and stock. I believe that the condemnatory reaction arose not from the sums involved and notions of “justice” and “fairness,” but from the fact that this phenomenon deeply offended the cultural and ethical sensibilities of Americans. Instead of standing at attention on their sinking ships while the passengers got out, CEOs commandeered the lifeboats and left those who depended on them to drown.
The concern with high pay is not an answer. American society, after all, tolerates extreme inequality in pay—college presidents, the critics of capitalism on campuses and on Wall Street; media anchors, in fact; virtually everyone enjoys salaries and emoluments that appear outrageous to someone else. In India, when we espoused socialism, the cynical definition of outlawed luxury was goods that the socialists did not (presently) consume. Once I was at a Planning Commission seminar and a socialist planner said we should not spend scarce foreign exchange on importing lipstick. Instead of arguing the economics of what he had said, I simply said that, even as he spoke, I could smell the imported Brylcreem in his hair.
We need to take a different turn. Bill Gates and Warren Buffet offer splendid examples of great, capitalist fortunes put to social use, making the capitalism they exemplify more palatable. When modern corporations do this, we call it corporate social responsibility. More of this will clearly have to be done.
But we also need to respond to the steady erosion of the American myth of mobility. Today, after nearly a quarter century of wage stagnation, and growing evidence that educational access for the poor has also declined, that myth is in a disastrous decline.
We have to respond by improving education and by relieving anxiety through reforms that make health care part of a basic provision for the poor. These reforms strengthen capitalism. Without them, the economic populists will enjoy a success that they do not deserve.
Jagdish Bhagwati is University Professor and Senior Fellow in International Economics at Columbia University. He is the author of In Defense of Globalization (Oxford, 2004) and Termites in the Trading System: How Preferential Agreements Undermine Free Trade (Oxford, 2009).