The Hindu Business Line : Capitalism, socialism and democracy

The capitalist class tends to destroy itself by its very own success and brings in more socialism that would involve huge bureaucratic management of productive resources. This is just what appears to be unfolding in the US now.

C. Gopinath

With due apologies to economist Joseph Schumpeter, I couldn’t resist borrowing the title of his book (1942) for this column. The current events in the US are most aptly summed up by that title.

This is the heartland of capitalism and democracy, propagating both around the world, and a land where socialism is a bad word. It is enough to get the career of any budding politician suspected of harbouring socialist sympathies get nipped in the bud .

But if you tuned into the talk shows and radio programmes these last few weeks, you would think you were living in the old Soviet Union! Caller after caller would rave at what is wrong with capitalism, and how the senior executives of the financial institutions have pocketed millions while driving their firms into the dust. Many opposed government intervention on ideological principles that the market needs to sort out the problems itself and the stockholders of these institutions need to pay the price, and others called for government assistance for embattled mortgage holders.

It is becoming increasingly clear that this is not a financial crisis anymore but a general economic crisis. As the catch phrase goes, it has spread from Wall Street (financial) to Main Street (the general economy). The markets got another shock when they saw the unemployment figure hitting new highs. The drying up of credit in the system has begun to squeeze all, especially consumer confidence. The drying up of consumer loans is affecting sales of automobiles and other durables, with repercussions for other industries.

Small businesses are finding that their working capital limits are running short. Even GE, the bluest of blue chip companies, decided that it needed a cash injection and issued common and preferred stock. Expert forecasters are unable to provide reasonable estimates of the effects of these events except to suggest that recession is either already here or certainly on its way.

The problems of the US financial systems have begun to spread to economies in Europe, Korea and elsewhere. With such prognostications, there was no option but for the US government to come up with a plan to save the institutions and put some liquidity back in the system.

A worrisome trend is the re-structuring of the financial firms that is taking place. In the last few weeks, JP Morgan Chase bought Bear Stearns and then Washington Mutual; Bank of America bought Countrywide Financial, and then Merrill Lynch; and Citigroup was allowed to buy Wachovia. These three now account for 30 per cent of all bank deposits in the US. These kinds of mergers usually take months of due diligence and still they fail.

Citigroup, which was under market pressure to slim down and improve its efficiency before the financial crisis reached a crescendo, must have been pleased at being asked to save Wachovia, except that Wachovia has instead found its own partner in Wells Fargo and does not want the government’s help or Citigroup’s embrace. Both Citigroup and the federal government, which arranged the so-called rescue, are upset. It is ironical that the government, which professes market solutions, is not just laying down the policy and the guidelines but also involved in the rescue of individual firms, one at a time without an announced policy.

Headed for a repeat?

I worry that we are setting ourselves up for a repeat of the problems that we are facing today. For one, the new institutions that have gorged themselves with cheap assets have become, yes, too big to fail! So when they are in trouble, we will again have the tax payer rushing to rescue them. And surely, they will fail, sooner or later.

We have created the moral hazard problem all over again. Since they are too big, and too critical to the financial system, to fail, it reduces the risk for existing managers exposing them to the ease of making poor moral judgments. They will make riskier bets, knowing they will be bailed out.

The nature of the distribution of power between the executive and parliament, combined with the weak presidency at the tail end of its tenure, and members of parliament trying to safeguard their image on the eve of elections ensured that it was not going to be easy to pass the bailout Bill.

It did not pass muster the first time aroundWall Street, which has been funding the elections of many politicians for many years, and which has provided many senior members of many presidential cabinets, continues to exert its lobbying muscle.

Nobody seems to be in charge

It is disturbing that the manner in which the federal government has been functioning gives the impression that there seems to be nobody in charge! The check and balance system of US democracy is feeling the strain of decision making. Members of the two houses of parliament are pulling in different directions trying to see what each interest group can get hold of, in the present crisis. After the first time the $700-billion bailout plan failed, members whose votes were needed for passage of the Bill managed to get their interests served by introducing revised deposit insurance limits, tax cuts, mental health schemes, and so on into the Bill which ensured that it passed the second time (officially called the Economic Stabilisation Act). It is even difficult to wrap one’s mind around the amount of the bailout. For a perspective, it is about the size of the GDP of the Netherlands, and five times the GDP of Pakistan.

The final bailout plan is designed to buy all the illiquid mortgages, securities, and other assets that have clogged the system. But the debate continues to rage as to whether it is a ‘bailout’ or a ‘rescue;’ whether it will prop up the financial system and existing power structure versus save the economy from collapse.

The confusion in the markets has put the cat among the pigeons of the political parties too. The Republicans, who have tended to argue in favour of small government and freer markets, are now in favour of more regulation of the financial institutions. The Democrats, who are ready and willing for more government intervention, wanted it to help home mortgage holders in trouble. Meanwhile, the Treasury is gearing up to fling about money hoping that the bleeding would stop. The plan, which will neutralise the bad assets, will help ease the liquidity in the system, but does not disturb the equity structure, worsening the moral hazard issue.

Haphazard regulation

Regulation has been haphazard and there is no clear trend of what is the underlying philosophy that is going to guide governmental decision making. On the one hand, we have regulations that worked well being scrapped. The separation of investment banking and commercial banks that was put in after the Depression has been given up. In a complete reversal, investment banks such as Goldman Sachs and Morgan Stanley are now allowed to take deposits and become retail banks. Meanwhile, short selling of stocks has been stopped. Even a rule change is being attempted.

The Financial Accounting Standards Board is under pressure to relax its ‘mark-to-market’ requirement. This means that institutions do not need to report the value of their assets based on current value but what they reasonably expect the value to be. Nobody knows what the true value of the asset is and the current market value is a fair approximation if we believe in the market process. To rely on the institution’s valuation is to take a leap of faith. Another hallmark of US capitalism is also under attack. The bailout legislation includes a provision to limit the pay of the leaders of the institutions that will take the government’s help. Perhaps the argument is that the astronomical salaries given to those positions attracted the wrong kind of talent!

Which is a good time to mention that the last chapter of Schumpeter’s book is titled ‘The march to socialism.’ In that he brings to a conclusion his thesis that the capitalist class tends to destroy itself by its very own success and brings in more socialism that would involve huge bureaucratic management of productive resources. It should be made required reading for the members of the US Congress.

(The author is professor of international business and strategic management at Suffolk University, Boston, US. blfeedback@thehindu.co.in)

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