How Capitalism Will Save Us

by Steve Forbes

  For decades, until the current recession, U.S. unemployment has been significantly lower than in most nations of Europe, where hiring and firing and new business formation and closings are heavily regulated by government in the name of creating a kinder, gentler capitalism.

  Competition can be rough in a free market. But it also compels people to do things better. Individuals hone their skills; companies improve quality and cut costs. The result tends to be better, cheaper products. Society as a whole benefits. A study by the McKinsey Global Institute, for example, suggested that competition was at least as important as technology in improving a business’s productivity and innovation—its effectiveness in serving its customers.2

  Thanks to growth created in part by the “brutality” of democratic capitalism, a middle-class American commands a greater variety of goods and services and better health care than any monarch in the nineteenth and early twentieth centuries. No doubt individuals as well as organizations can experience failure in a free market. And for some, those failures are acutely painful. Yet thanks to the flexibility of our economy, those who suffer setbacks have a greater chance of recovering and eventually succeeding.

  Q BUT DOESN’T CAPITALISM PRODUCE DEVASTATING ECONOMIC TRAUMAS SUCH AS THE FINANCIAL CRISIS OF 2008, WHICH DESTROYED TRILLIONS OF DOLLARS OF WEALTH AND MILLIONS OF JOBS?

  A NO. THE WORST HISTORIC DOWNTURNS ARE TYPICALLY CAUSED BY MASSIVE GOVERNMENT INTERVENTION IN THE ECONOMY. UNCLE SAM’S LOOSE MONEY POLICIES AND ITS DOMINATION OF THE MORTGAGE MARKET SET THE STAGE FOR THE 2008 FINANCIAL CRISIS—ENCOURAGING RECKLESS MORTGAGE LENDING AND OVERHEATED FINANCIAL MARKETS.

  When the economy goes through a major downturn, políticos and pundits inevitably blame capitalism. The last few years have been no exception. The collapse of the subprime-mortgage market and the credit crisis that followed have been widely blamed on “unfettered markets.” Congressman Barney Frank, chairman of the House Financial Services Committee, declared the crisis the fault of “the private sector”3 and “predatory lenders.”4 “Wall Street greed” was blamed not only by Democrats but Republican candidates in the 2008 presidential campaign. John McCain attributed the crisis in part on “a casino on Wall Street of greedy, corrupt excess—corruption and excess that has damaged them and their futures.”5

  Finger-pointing like this, however, obscures a Real World economic truth: what is often blamed on free enterprise is in fact the result of price or supply distortions created by government.

  We’re not saying that all downturns are government created. There’s a distinction to be made between catastrophes like the 2008 credit crisis and ordinary business cycles produced by the forces of marketplace creative destruction. Normal downturns can be caused by—to give an example—too many companies entering a market. In the early 1980s numerous players jumped into the personal-computer business. Most failed. This kind of turbulence, while painful, is part of the economy’s process of change, whereby new technologies and ways of doing things supplant the old, creating more jobs and higher levels of prosperity.

  Recessions produced by such normal cycles, though, are usually not long lasting. But the very biggest traumas, such as the 2008 meltdown of the credit and housing markets, are not made by free markets. They result from government intervention that didn’t allow markets to work.

  Few people fully appreciate the extent to which the behavior of markets is influenced by government, with its mammoth powers of regulation and taxation and ability to direct, indeed to print, trillions of dollars. This immense power was a key determinant in both the subprime collapse and the credit crisis.

  We began to outline government’s role in the crisis in chapter 1. The financial crisis in fact was the by-product of not one but three government-created disasters. The first was in monetary policy. The housing bubble would not have reached its immense size without the Federal Reserve’s low-interest-rate, “easy money” policy of the early 2000s. In 2003–2004, the Federal Reserve made a fateful miscalculation, believing that the U.S. economy was much weaker than it was. The Fed therefore pumped out excessive liquidity, printing dollars and keeping interest rates artificially low. That affected not only housing, but also the entire economy.

  When too much money is printed, the first area to feel it is commodities. (They’re traded globally on a daily basis in dollars and are therefore more sensitive to changes in the money supply than, say, a fixed asset like a home that is sold every few years or months.) Thus the Fed begat a global commodities boom as the price of oil, copper, steel—even mud—shot up. The price of gold roared above its average of the previous twelve years. For nearly four years the dollar sank like a rock in water against the euro, yen, and pound.

  The already booming housing market exploded. Housing was experiencing above-average price rises because of a favorable change in the tax law in 1998 that virtually eliminated capital-gains taxes on the sale of most primary residences. Now with money easy, a bubble mentality took hold. The reasoning was that housing prices always go up; therefore, lending standards could be safely lowered.

  We described in chapter 1 how people were swept up in this manic optimism: so what if a dodgy borrower defaulted? It didn’t matter—the value of the house would always be higher.

  No doubt some lenders became aggressively reckless. One homeless man reportedly got to buy a $700,000 house. Mortgage underwriters in institutions like Washington Mutual were under severe pressure to process mortgages, quality be damned. So-called teaser rates proliferated. A borrower would be given a very low rate at the beginning of the mortgage, which would be jacked up after a given period. Such a higher rate might be beyond the borrower’s ability to pay. But not to worry. Many of these borrowers were assured that they could refinance with a new teaser rate.

  The housing debacle could never have happened on such a catastrophic scale without the government’s easy-money policy. Yet the Fed’s error was studiously ignored by most policy makers as well as the mainstream media.

  Disaster number two: government-created mortgage giants Freddie and Fannie helped inflate the balloon still further. As we mentioned in chapter 1, Fannie and Freddie dominated the subprime market. With $1 trillion in assets and more than $53 billion in revenues, Fannie Mae was in 2004 the nation’s twentieth-largest corporation and the second-largest financial institution in the country, right behind Citigroup. Freddie Mac, meanwhile, held some $800 billion in assets in 2007.

  By 2008, Freddie and Fannie bought, packaged, and guaranteed more than $1 trillion worth of less-than-prime mortgages, selling them as securities to investors. These securities—remarkably—were rated “triple A” by rating agencies, in an extraordinary bout of hallucination.

  The third government disaster bringing on the financial meltdown was a succession of regulatory failures. The worst by far was the refusal by regulators to back off “mark-to-market” or “fair value” accounting rules, which gratuitously destroyed banks and insurance companies. A concept floating around since the 1990s, mark-to-market accounting got a push from the corporate scandals that engulfed Enron and others. The intent was to compel public corporations to increase accounting transparency.

  Mark-to-market required financial companies to adjust the value of their regulatory capital—to mark it down or up—to what they would command on the open market. These changes would “have to flow through” the companies’ profit-and-loss statements. In other words, if the value of a bank’s securities went down, it would have to show a charge. The rule meant that the bank had to raise capital in order to restore its balance sheet.

  One fundamental problem was that not all assets on a balance sheet are necessarily saleable at a given moment. For example, what if you had to state the value of your home based on what you would get if you had to sell it today? That number might be zero. But if you sold it under normal conditions, the house’s ordinary value might be $400,000.

  In much the same way, mark-to-market accounting forced banks and insurers to adjust their capi
tal accounts to reflect what their financial assets were worth, as though they suddenly had to be sold on the open market. During the financial crisis, it encouraged undervaluation of assets—including perfectly good loans.

  Yet regulators and lawsuit-fearing auditors insisted that solvent financial institutions drastically write down the value of their entire mortgage portfolios, the good loans as well as the bad. This meant banks had to raise more capital, sending distress signals to the market that forced down their stock prices. Result: hedge funds smelling blood started shorting financial stocks.

  The frenzy of short selling sent financial stocks into a death spiral. Companies saw their credit ratings downgraded by agencies that had lurched from easy indulgence to mindless overreaction.

  Of the $600 billion financial institutions wrote off between the summer of 2007 and the fall of 2008, almost all were book—or artificial—losses and not actual cash losses. If the mark-to-market rule had been in effect during the banking crisis of the early 1990s, almost every major commercial bank in the country would have gone under. There would have been a second Great Depression.

  Tragically, the Bush administration did not comprehend the damage caused by mark-to-market. Not only banks but also life insurers had to raise capital to cover the supposed decline in the value of their financial reserves, even though those assets had little or no relation to their day-today operations or viability. They were intended to cover liabilities arising from future claims. No matter. Otherwise healthy companies such as Hartford Financial found themselves in a near death spiral. Hartford saw its stock plunge from $72 a share in 2008 to a low of $3 before state insurance regulators stepped in with their own accounting relief that reduced pressure on life insurers.

  The maniacal short selling that helped drive down both insurance and banking stocks was made possible by still another governmental misstep—removal of the uptick rule that had provided a critical speed bump to slow short selling.

  The uptick rule was enacted back in 1938 to stop the bear raids that devastated companies in the 1920s and ’30s. Raiders would pick a stock, spread rumors that it was in trouble, and sell it short relentlessly, hoping to create panic. In this way they would force the price into a downward “death spiral,” then they would buy the stock back at a considerably lower price and make a profit. Allowing a short sale only after a stock went up from its previous price, the uptick rule had served as a critical speed bump, preventing or slowing bear raids. Suspending it heated up volatility, deepening the atmosphere of anxiety and uncertainty.

  The 2008 economic meltdown precipitated by these mistakes is just the latest economic catastrophe caused by the less-than-invisible hand of government.

  Missteps of a different kind helped produce the Great Inflation of the 1970s. Contrary to what many believe, neither oil speculators nor OPEC caused the soaring fuel prices of that era. The true culprits were the Federal Reserve and Washington politicians like President Richard Nixon, who weakened the dollar by severing its anchor to gold. That set off massive printing of money not only in this country but around the world, causing three ever-more-debilitating bouts of inflation and stagnation.

  The most powerful example by far is the Great Depression. More and more people are becoming aware of the government’s role in that disaster, brought on in the fall of 1929 by the introduction in Congress of the Smoot-Hawley Tariff. That protectionist bill was designed to shield American farmers from foreign competition, keeping out or restricting agricultural goods from Canada and elsewhere. It was later expanded to protect a vast array of industrial products. Even imported olive oil was hit with huge taxes, although the U.S. was not a producer. Markets try to anticipate the future, and with this disaster looming, the stock market crashed. When Smoot-Hawley looked as though it would be sidetracked, the stock market rallied and ended the year almost where it had begun.

  The bill reemerged in 1930 and stocks plunged again. When President Hoover finally signed it that June, decline turned to disaster. Countries retaliated and trade shriveled. International flows of money dried up, severely damaging countries’ financial systems.

  Then, President Herbert Hoover proposed and Congress passed a gargantuan tax increase in 1932. The top income-tax rate was boosted from 25 percent to 63 percent. There was even an excise tax on checks. You had to pay a tax each time you wrote a check! The intention was to “restore confidence” by balancing the budget. Not surprisingly, confidence was anything but restored. Strapped consumers responded by using more cash. These withdrawals from banks nearly broke the financial system, forcing the new president, Franklin Roosevelt, in 1933 to close every bank in America for several days.

  Roosevelt then made numerous mistakes of his own—such as instituting industrial codes that tried to micromanage prices, wages, and even selling practices throughout virtually every sector of the economy—that further retarded economic recovery. Yet it was the “economic royalists” and “plutocrats”—the selfish rich people—who were blamed for the miseries of the 1930s.

  True, there had been excesses in the private sector in the heady precrash days of the 1920s. But these alone could never have caused a decade-long catastrophe that encompassed the entire economy.

  Stock market breaks in and of themselves do not bring economic downturns. In spring of 1962, Wall Street had the biggest stock market bust since 1929. But no depression followed. Unlike Roosevelt, President John F. Kennedy backed off some of his earlier antibusiness actions, such as the raids by his attorney-general brother on steel company executives. JFK actually introduced major tax cuts, which helped make the 1960s the most prosperous decade up until that time in American history.

  And why was there no depression or even recession in 1987 after stocks had their worst one-day crash in history—down 23 percent? That’s because President Ronald Reagan did not respond to that crash with tariffs or taxes. Nor did he enact obese stimulus packages. Instead he allowed his scheduled tax cuts to take effect. Stocks recovered. And the economy continued to grow.

  People blame the private sector during economic disasters. Yet government policy causes the worst instances of economic brutality.

  One final example: the momentous government blunders—again in monetary policy—that were made in Germany during and after World War I. Instead of paying for the war through a judicious mix of taxes and borrowing, Berlin simply turned on the printing press. The resulting flood of money into the economy created raging inflation that was blamed initially on the need to pay for the war—and later on the need to raise money to pay reparations to the Allies. Instead of fully comprehending the cause, the public as always sought scapegoats. Blame shifted to Jewish financiers, “speculators” who “stabbed” Germany in the back. After catastrophic inflation wiped out the foundations of the middle class, Germany became ripe for both Nazism and communism when the Great Depression hit in 1929.

  REAL WORLD LESSON

  The biggest economic catastrophes result not from unfettered capitalism but from interventions by government.

  Q CREATIVE DESTRUCTION MAY HELP THE LARGER ECONOMY, BUT WHAT ABOUT THE PEOPLE WHO LOSE THEIR JOBS?

  A MOST PEOPLE REBOUND RELATIVELY QUICKLY. EVEN IN A RECESSION, JOBS ARE NOT ONLY DESTROYED, BUT ALSO CREATED.

  Losing a job is painful. But it is particularly scary in a down economy. Media headlines such as “Job Losses Worst Since 1974” and “Worst Financial Crisis Since the Great Depression” convey the impression that things are only going to go downhill. That you’ll never get another job. Even during the period of growth that preceded the 2008 crisis, when unemployment was barely 5 percent, gloom sayers complained about a “jobless recovery;” others complained that the jobs being destroyed were being replaced by low-wage, menial jobs like chain-store cashiers and burger flippers.

  Media stories characteristically focus on mass layoffs and jobless statistics. This is not only an immense disservice, but also a distortion of what is taking place in the Real World economy.

 
The Real World truth is that even in the worst recessions, jobs are being created as well as lost. And most people find new employment, sooner rather than later.

  At the end of 2008 the median amount of time a person was unemployed was ten weeks or two and a half months, according to the Bureau of Labor Statistics. That means half the people were jobless for less than that amount of time.6 In 2009 the length of joblessness increased because government blunders—like the Federal Reserve’s failure to revive credit markets—seriously hobbled the normal forces of recovery. Even so, only a little more than a fifth of those jobless were classified as long-term unemployed, that is, out of a job for twenty-seven weeks or more.

  During the severe 1980–82 recession, when unemployment reached nearly 11 percent, most people found new jobs in a relatively short period of time. Most, in fact, found jobs as good as or better than the ones they had lost. Unlike the administration today, Ronald Reagan enacted progrowth tax cuts.

  In addition to jobless statistics, the Bureau of Labor Statistics recently has started measuring what it calls Business Employment Dynamics—the number of jobs both created and lost in the economy. During the second quarter of 2008, when the country had slid into what was believed to be the worst downturn since the Great Depression, 7.8 million jobs were lost. But at the same time some 7.3 million were created.7

  This is what economists refer to as “churn,” which is always taking place. Economists Clair Brown, John Haltiwanger, and Julia Lane report that from the mid-1990s to the mid-2000s—a period encompassing the 2000–2001 recession—private-sector job creation and job destruction rates each have averaged almost 8 percent of employment per quarter.8 About one in thirteen jobs is destroyed every quarter. But a slightly higher number of jobs are created on average, resulting in relatively moderate increases in the overall number of jobs.