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what the current crisis teaches us about capitalism or why I’m not a libertarian

September 14, 2009

(A review of past thoughts on the economic crisis one year later.)

From my perspective, the current economic crisis reinforces the idea that, barring a revolutionary economic transformation, capitalism needs to be regulated in order to prevent, or at the very least limit, the exploitation of labour, the negative effects of externalities and, of course, economic crises. The current financial crisis itself could’ve been avoided, and, using them as an example, so could AIG’s near failure.

It’s rather complicated to explain exactly what happened with AIG, but the bottom line is that AIG’s financial sector was paid by investment companies to back up securities that were in turn backed by pieces of mortgages. AIG effectively promised to make up the difference if the investments failed. So where did they go wrong?

It seems that AIG, thanks in part to Gary Gorton, the finance professor who designed AIG’s risk models, figured that being paid to take on these risks was “free money” because they never thought they’d have to make any payments to cover actual defaults. What they apparently didn’t take into consideration, however, was the potential write-downs or collateral payments to trading partners (How AIG Failed). But specific regulations dealing with these securities and mortgage default swaps could’ve possibly prevented all of this. This is where both the company and the government failed.

David Swensen, the person who’s credited with creating derivatives or “swaps,” eventually paved the way for an entire industry to be built around creating and trading derivatives based on mortgage payments of homeowners (Inventor of the “Swap” blames regulators for Financial Crisis). In the case of AIG, they basically insured these mortgage-backed securities. But the government was seemingly reluctant to regulate these derivatives and the industries that had developed around them, and traders eventually abused them to the point of financial collapse. Part of this was due to the perceived benefit of these swaps by people like former Fed Chairman Alan Greenspan. As Bob Moon notes, “… he called credit default swaps “probably the most important instrument in finance,” because they were supposed to spread risk around and stabilize the market” (Banks deep into unregulated ‘gambling’).

The sad fact is that stricter regulations and oversight on the part of the government, plus more transparency and less greed on the part of financial institutions, could’ve prevented much of this from happening, including what happened with AIG. Swensen himself says that he supports “requiring swaps and other derivatives to be traded openly on an exchange” since it’d reduce the risk, but surprisingly, this very proposal was “torpedoed by both the Clinton and Bush administrations.” Why? Swenson theorizes that, “Financial institutions that deal in these things have resisted that because it would make the market more transparent and less profitable” (Inventor of the “Swap” blames regulators for Financial Crisis).

With respect to the banks that where involved in this, I think that stricter regulations and oversight on the part of the government would have helped prevent much of their irresponsible behavior as well. The banks themselves didn’t keep proper track of who actually held all the risks, and essentially thought they were spread the risk to other institutions, but in fact they were just spreading it amongst themselves. It can be argued that this wasn’t due to regulation or deregulation so much as stupidity on their part, but I agree with Marcus Baram and others that the passage of the Financial Services Modernization Act of 1999 “reduced decades-old regulations separating banking, insurance and brokerage activities” and “helped to create the current economic crisis” (Who’s Whining Now? Gramm Slammed By Economists).

As Mark Sumner points out in his article, “John McCain: Crisis Enabler,” the Financial Services Modernization Act of 1999 made it possible for large commercial banks to become even larger, as well as to become “directly involved in the stock market, bonds and insurance,” and that the Commodity Futures Modernization Act “expanded the scope of futures trading” creating “new vehicles for speculation and sheltered several investments from regulation.” And I think it can be reasonably argued that this is one of the main ways financial institutions that were ‘too big to fail’ were able to get into the position of failing.

That’s why I’m convinced that, at the very least, the U.S. must adopt an economic model similar to those that have taken shape in Europe — with a mixture of capitalist and socialist aspects — out of sheer pragmatism.

For example, in a broader context, I’ve found some of Karl Kautsky’s concerns regarding the drawbacks and weak points of the capitalist system amazingly prescient, especially in regard to commerce and credit, although the fact that he was decidedly biased against it seems to have blinded him to the potential ability of future generations to solve some of these problems. Nevertheless, I’ve found many his arguments against the capitalist method of production to be rather strong, even eye-opening.

The beginning of chapter three of Kautsky’s The Class Struggle, for example, provides a simple yet excellent overview of one of the main causes contributing to the current world-wide economic crisis. In regard to credit, he notes that, “Credit is … much more sensitive than commerce to any disturbance. Every shock it receives is felt throughout the economic organization” (47). Besides making a strong argument for why this type of system makes it increasingly more difficult for small production (e.g., small farmers, small business owners, etc.) to succeed, he stresses that this credit based system ultimately renders modern industry “more and more complicated and liable to disturbance, to carry the feeling of uncertainty into the ranks of the capitalists themselves and to make the ground upon which they move ever more uncertain” (48).

But the type of careful direction that is needed to insure the uninterrupted operation of this modern system of production is hindered by the very institution of private property on which it is founded. As Kautsky summarizes: “While the several industries become, in point of fact, more and more dependent upon one another, in point of law, they remain wholly independent. The means of production in every single industry are private property; their owner can do with them as he pleases” (50-1).

So for these reasons, among others, it’s apparent to me that to be able to effectively manage a world-wide, credit based economy, a certain amount of outside interference is unavoidable because without a certain amount of intervention, whether in the form of stricter regulations and oversight or outright nationalization, the market system is extremely vulnerable to abuse and disruption. And even these steps may not be enough.


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