To paraphrase Winston Churchill, "[capitalism] is the worst form of [economics] except all those other forms that have been tried from time to time."
I subscribe to capitalism with the same sense of faith and irony. As I mentioned in my previous blog post, it is compelling that the financial services industry should be such an incredible example of capitalism's failure. Of course, I do not believe capitalism itself has failed. It hasn't even had a chance to succeed. Bribery (under the guise of campaign contributions), regulatory capture and lobbyist influence -- these noxious forces have corrupted our political and economic system.
Markets are the bedrock of capitalism, theoretically enabling efficient allocation of resources and price discovery. In reality, they have become simultaneously beholden to the manipulation of the Federal Reserve and a veritable casino of poorly regulated (or completely unregulated) gamblers and speculators, with incredible brain power and unprecedented computational resources. While markets yearn to be free, we have long accepted that regulations are necessary to curb market excess and ensure fairness. Matt Taibbi argues: "In a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy."
As such, unregulated markets spin out of control, much in the same way as poorly regulated markets do. We have too much of both today, and it has imperiled our global economic system.
While High-Frequency Trading has (justifiably) been a favorite target, it is only symptomatic of a much larger, more fundamental problem. Other evidence for this include:
- Too Big To Fail Institutions ("TBTF") and the Repeal of Glass-Steagall: TBTF would not exist in a truly capitalist system. They are created through regulatory capture and government subsidies. And yet, our government not only subsidizes these "Systemically Dangerous Institutions" -- as Bill Black so eloquently labeled them -- it has even forced smaller institutions to join forces to become far more systemically dangerous (e.g. Bank of America + Merrill Lynch; JP Morgan + Bear Stearns).
- One cannot meaningfully discuss TBTF without recognizing its relationship to the Glass-Steagall Act. The Glass-Steagall Act mandated a separation between commercial and investment banks; essentially, Congress tried to protect the financial services industry from the weight of its own heft, and this worked for nearly 70 years. For example, as Luigi Zingales points out in a recent Financial Times op-ed, the 1987 stock market crash did not impact the economy, because commercial banks were unaffected. Likewise, Zingales notes, "securities markets helped alleviate the credit crunch (of the early 90s) because they were unaffected by the banking crisis."
- The Financial Crisis of 2008 offered a clear illustration of what happens when investment and commercial banks commingle. Quite simply, TBTF did just that -- the private sector failed, and the public has had to pay the price. The mess has compounded daily since then, with no end in sight.
- The Sheer Size of the Industry: As institutions have grown "too big to fail", the industry itself has taken on a much larger and more concentrated (and therefore more problematic) share of GDP. Our financial services industry has transformed from a capitalist-based survival-of-the-fittest to a moral-hazard-based survival-of-the-biggest.
- A dramatic shift took place starting in the 1990s; Alan Greenspan dropped the Fed Funds Rate and kept it low for an extended period of time. The financial services industry, which had never comprised more than 1.7 percent of GDP (and had averaged just 1.2 percent) from 1929 - 1988 suddenly started growing to peak at an unsustainable 3.3 percent of GDP in 2005.
- New York Times writer Floyd Norris blames excessive risk-taking and an unregulated derivatives market for this concentrated spike in the industry's share of GDP. In this connection, it is hardly a wonder that our outsized financial services industry has pushed society away from fair, orderly markets and into a spiraling series of bubbles and crises.
- Historically extreme compensation. To quote the man of the hour, Jamie Dimon, "They want Wall Street to pay... They think we're overpaid assholes." It's true. And you are. I mean, I know you're doing "God's work" and all, according to Lloyd Blankfein of Goldman Sachs, but your dramatic emphasis on short-term profits over prudent long-term financial stewardship is killing our economy. And you don't care, because you just keep getting your bonuses.
- A complete lack of criminal enforcement. Capitalism depends on the rule of law to function. Instead of prosecuting criminals this time (as they did during the Great Depression) the government is instead bailing them out (and reaping the campaign donations). In fact, the government has taken a number of recent steps to loosen the prosecution of white-collar crime. For example, in 2008, the U.S. Dept. of Justice implemented a policy allowing for the deferral of prosecutions for corporations that show self-investigation and reporting. Great timing, DOJ! With the SEC also adopting this policy, you have tremendous accounting control and institutional fraud from the mortgage crisis going largely unpunished or simply wrist-slapped. Nobody goes to jail.
- The unregulated shadow banking system. The previous symptoms were all within a supposedly "well regulated" market. There exists a much more insidious example of a market that has remained unregulated -- the shadow banking system and the unregulated derivatives market. This market encompasses both derivatives instruments such as mortgage-backed securities, credit default and interest rate swaps, and other such instruments that are "too exotic" to be understood, let alone regulated. This is a complex subject that is difficult to tackle in a bullet point. This chart from Reggie Middleton's BoomBustBlog.com should suffice as it demonstrates that in 2008 (the numbers are worse now) the notional value of JP Morgan's derivatives portfolio was six times US GDP and larger than Global GDP by $21 billion. Of course, I'm sure they know what they're doing, and would never endanger the global economic system by managing that risk recklessly. Banking used to be a boring business -- our economy would be much more stable and our country much wealthier (with a more even distribution of wealth) if it headed back in that direction.
Of course, this post is really just a tip-of-the-iceberg treatment of a topic that has been covered extensively. Unfortunately, movements to reduce partisanship and the influence of money on the financial services system are met with tremendous resources -- political, financial and media -- that also seek to preserve the status quo. I am not suggesting that we seek an alternative to capitalism, as we've seen that other economic systems fare as badly or worse (see: USSR, Europe). But we do need to refom our government and regulators, starting with the two-party duopoly and the campaign finance system. These dramatic reforms might give capitalism a chance to function.
In my next blog post, I'd like to delve deeper into some proposed reforms for financial services in our continuing search to create a more just and equitable economic system. As I've mentioned, I believe economic and political reforms must go hand-in-hand. It does us no good to attack the squid when it's feasting on an unending food supply of corruption that will just spawn another in its place.