By Mark Hager
Marxists are feeling smug. The 2008 financial crisis confirms their thesis of capitalism’s long-term unsustainability and ultimate collapse. They argue that as capitalism matures, average profit rates trend downward, converging toward zero. As this happens, capital increasingly flees productive deployment in favor of nonproductive speculation in a more and more bloated financial sector where it strives vainly and destructively for sustainable high returns. Increasingly exotic and complex risk-taking yields ever larger and more frequent financial meltdowns, with catastrophic consequences throughout the world economy. No set of policies—regulatory or deregulatory, deficit spending or budget balancing, free trade or protectionist—can stave off the market system’s inevitable stagnation at a point leaving much of the world impoverished.
It’s hard to say all this is wrong. Though Marxist explanations differ among themselves on why average long-term profit rates must fall—I will not get into that right now—their arguments are rigorous on their own terms and rest on concepts and assumptions as plausible as anything else in economic literature. Even if they are true, however, we need to wager they are false.
In their long-run critique of the market system, Marxists seldom even attempt to explain how a non-market economy could match competitive markets in inducing fruitful innovation and allocating resources efficiently through the pricing system. Moreover, their counsel that nothing can prevent capitalism’s financial crises or ameliorate their effects is one we cannot afford to heed. We must assume they are wrong and try what we can. Marxist advice in one recent piece is to replace capitalism with an economy of “human development, ecological plenitude, and…genuine human community.” Rats, why didn’t I think of that?
Marxists are not the only ones theorizing about inevitable crises. Many observers agree there are built-in tendencies toward financial meltdowns, without accepting the Marxist view that they are leading toward capitalism’s terminal paralysis. After surveying the literature, law professors Jeffrey Gordon and Christopher Mullen stress three features that may make financial crises inevitable.
First, banks and quasi-banks are inherently unstable because withdrawals may at any time accelerate suddenly if depositors perceive risk, but long-term loans and other bank assets are too illiquid to satisfy massive and instantaneous cash-out demands. Interlocking credit and risk can transmit the resulting panic from one bank to others, touching off contagious meltdowns. The whole sector is inescapably fragile. Stabilizing mechanisms have evolved, to be sure: interbank and central bank lending, regulations like mandatory deposit insurance and capital requirements. But firms devise practices that elude regulation, while of course remaining within the unitary and interlocked financial system. As this “shadow banking” proliferates, stabilizing regulation loses force. The system as a whole remains perpetually vulnerable.
Second, the finance sector fuels asset bubbles and insecure loans during expansionary surges, to the point of inevitable unsustainability. As profits grow increasingly large and reliable during expansion, financiers demand less security for loans. Loans go out faster and faster, fueling profits in a positive feedback loop as both lenders and borrowers abandon caution. Assets meanwhile get bid up in price as easy credit increases the active money supply. Appreciating assets become collateral for increasing loans, pushing asset prices upward still further and stimulating efforts to increase their supply. Inevitably, however, loans on nonviable projects pile up and markets notice that assets are priced beyond actual productive potentials. Defaults then accelerate and assets deflate while sectors supplying those assets (condos, for example) collapse. Goodbye easy credit, hello crisis.
Regulation can theoretically encourage counter-cyclical behavior, constraining credit in good times through increased compulsory reserves, for example, and doing the opposite during downturns. With strong financial regulation, Canada dodged the recent crisis, just as the U.S. avoided crises during its strong-regulation period, 1945-1971. But let’s wait a while before cheering Canada (though they’re all very nice). Forced stability may stifle growth during expansionary phases: who’s to say such growth may not outweigh the subsequent contractions? And it’s not yet clear that regulatory contrivances can constrain unpredictable bubbles (and their subsequent collapses) over the long run. If Canada avoids crisis for the next two decades, maybe we’ve learned something.
Third, systemic risks posed by financial innovations can flip unforeseeably from minor to major as they expand, evolve and interlace with other financial practices. Innovations may start out in life reducing capital costs by fostering diversification, information processing or risk sharing before going toxic as they proliferate throughout the system and their own inherent risks begin to ripen. Where in that cycle should regulators intervene?
Securitization of subprime mortgages is a classic example. In its inception, it encouraged banks to issue mortgages to home-buyers who were relatively creditworthy despite troubles in their credit histories. Some banks were good at identifying such borrowers but were nevertheless gun-shy about carrying prolonged nonstandard risks on their balance sheets. Bundling mortgages into securitized packages and selling them to parties willing to accept the risks in return for high potential gains allowed banks to issue loans more freely. They could quickly sell them, wiping risks off their books and using proceeds to finance more loans. Liquidity increased, risk shared efficiently, the whole system sounder and more stable: so it seemed, so it seemed. It is hard to reckon with the system’s tendency to gulp too much of a good thing and blow past stop signs en route to the cliff.
Considering these perplexities, it’s little wonder regulators constantly get wrong-footed. When things are going well, anti-regulatory voices ring loud and clear. With their lobbying, election contributions and media campaigns, they warn against choking off the cascading riches produced by financial aggressiveness. When “geniuses” turn out to be bumblers, it’s way too late. Worse, regulation can itself be de-stabilizing in the long run as players start gambling under the false supposition that stabilizing mechanisms will keep the house from crashing.
Gordon and Muller conclude from all this that further crises lie in our future. They worry, moreover, that Dodd-Frank’s anti-crisis mechanism may make things worse, not better. Banning unpopular taxpayer bailouts like the one that helped end the 2008 meltdown, Dodd-Frank instead empowers regulators to take a financial firm into receivership if its failure poses systemic risk. Receivership would typically involve prolonged government control and eventual liquidation, with asset sales covering secured creditors first while sacrificing unsecured creditors and equity holders (not to mention the poor employees).
This may be a reasonable solution for a single tottering firm. But in a multi-firm meltdown it might mean nationalization and liquidation of virtually the entire financial sector, a prospect so drastic that regulators would hesitate long, perhaps too long, before declaring the emergency. Meanwhile, the very possibility of across-the-board nationalization might frighten investors into fleeing the whole financial sector, thereby triggering the very crisis Dodd-Frank hopes to forestall.
Many observers feel that emergency cash injections must remain on the table. Despite Dodd-Frank’s ban, as they point out, Congress could authorize a taxpayer bailout by simply repealing the ban. Gordon and Miller propose that emergency bailouts should come not from taxpayers but from the financial sector itself through a fund mandatorily financed (partly pre-financed) through assessments on firms according to size and risky-practice profile.
Marxists of course insist that neither this nor anything else will work. It’s like pouring money into a bad old car: “Why are you still driving around in that piece-of-crap economy? For just a small conceptual down payment, I can put you in a brand new economy today!”
Mark Hager is an American lawyer living in Pelawatte. A graduate of Harvard Law School, he consults with organizations as a writer and as a negotiation trainer with Sea-Change Partners.